The Treasury Inflation-Protected Securities (TIPS) are a kind of bond issued by the United States Treasury that was developed to safeguard investors against the possibility of price increases over the long term. They are debt obligations backed by the United States Treasury and come with a predetermined interest rate. As a result of the principle amount being continually modified in response to shifts in the Consumer Price Index, the dollar amount of the interest payment that is accrued on TIPS is subject to a fluctuating range (CPI).

The Dangers Involved When Investing in Individual TIPS

Because of the low danger of inflation and the low risk of the relative market, TIPS may be a reliable investment. However, Treasury Inflation-Protected Securities (TIPS) are not guaranteed investments, and their values are subject to volatility, just like other types of bonds. It is in the best interest of investors to have a solid understanding of the major rewards and dangers involved.

A person who stays on to a TIPS bond until it matures is not impacted by any price swings that occur between the time it is issued and the day it expires, even though the price of the bond will change between those two points in time. However, this modest degree of volatility can become problematic if an individual sells a bond before the day on which it is scheduled to mature. Because the bond's market price might be higher or lower than par at the time of the sale, it is not assured that they will get the bond's par value in this instance.

There is also the possibility that the official CPI may not accurately follow actual inflation or the growing costs of the items or services that the investor needs. This presents yet another possible risk associated with TIPS. In this scenario, there is a possibility that the inflation protection feature built into the bonds will not be enough to safeguard the actual buying power of the investor.

The very remote possibility of deflation, which would result in lower prices, is the third danger. If this were to occur, investors would likely sell their TIPS holdings, which would bring prices down since there would be no need for inflation protection. This took place at the worst of the financial crisis in 2008 when worries of a global financial disaster heightened the potential of deflation and led to a steep reduction in the values of TIPS in the fall of the same year. This took place in the context of the year's ongoing financial crisis. Deflation is a remote possibility, but it is nevertheless one that must be considered.

The Danger of Investing in TIPS Through Mutual Funds and ETFs

When investors purchase individual bonds and keep them until maturity, the Treasury Inflation-Protected Securities (TIPS) will function as intended. However, investors who hold TIPS through ETFs or mutual funds face another set of risks.

Since the principal value of the bonds owned by the funds would move higher with inflation, mutual funds may be considered to offer some kind of protection against inflation. On the other hand, in contrast to individual securities, bond funds do not have a maturity date. This indicates that there is no assurance that investors will get a return equal to their initial investment. Because TIPS are so sensitive to changes in interest rates, the value of a mutual fund or exchange-traded fund that invests in TIPS might significantly swing in a relatively short time.

The months of November and December of 2010 provide an excellent illustration of this risk. The 10-year U.S. Treasury note yield increased from 2.66% on November 1 to 3.30% on December 31 during these two months as bond prices plummeted and rates skyrocketed higher. The falling prices of bonds caused this. The biggest TIPS exchange-traded fund, the iShares Barclays TIPS Bond Fund (ticker: TIP), had a return of -3.8% over the same period. During the same period in 2013, the fund suffered another devastating loss of 8.1% when it was exposed to a similar increase in Treasury yields.

A Look at the Factors That Affect TIPS

Investors would be good to educate themselves on the elements that impact yield and price of fixed-income investment securities to obtain clearer grasp of TIPS. When investors have a better understanding of the factors that drive TIPS, they may more accurately understand the rewards and dangers associated with owning these assets. Changes in interest rates and forecasts for inflation are the key elements that affect tips.