Treasury Inflation-Protected Securities (TIPS) are securities issued by the government that adjust for inflation based on the value of the Consumer Price Index (CPI). Unlike other fixed-income investments, the face value (and therefore the interest income) varies over time based on the amount of inflation adjustment. This makes TIPS a good choice for a laddering strategy with medium- to longer-term fixed income investments.
Many investors ladder Certificates of Deposit (CDs), meaning they are purchased at regular time increments so there are always some that are maturing and available for cash if needed, or for reinvestment if they are not. You balance the maturity periods to keep a relatively stable and predictable income.
The downside of this with CDs is the relatively short timeframe (often a year or less) before maturity, and the fact that inflation can easily erode the relatively low returns from a CD. TIPS have maturity terms of 5 years, 10 years, or 30 years, so laddering TIPS allows you to have the same income laddering effect over a longer timeframe while hedging against inflation.
TIPS are purchased in $100 increments, and offered through auction at various times throughout the year. 5-year and 30-year TIPS are auctioned three times a year and 10-year TIPS are auctioned six times a year. You can purchase them directly through the US treasury by opening an account at TreasuryDirect.com – however, if you choose this path, you will buy via non-competitive bid, which means you accept the yield that is set during the auction process.
You can offer competitive bids by purchasing through a broker or financial institution (you can purchase non-competitively through there, also). In a competitive bid, you set the yield threshold that you will accept. You may receive only a part order or no order this way, so for a laddering strategy you will generally want to place non-competitive bids.
To ladder TIPS, decide how much you wish to invest in TIPS (in other words, how much fixed-income space you have in your portfolio), determine your future income goals, and lay out a strategy that meets your goals.
For example, if you are only concerned with a fixed-income component of retirement that is many years away, you are mainly interested in a relatively smooth predictable income from interest and regular maturities. You can stick with the higher-returning 30-year TIPS and purchase them in periodic amounts to match the income component you wish to have in those later years. (This approach immunizes you to a reasonable degree from fluctuations in the market value of your bonds, as it is your intention to hold them to maturity in any case.)
Assume a target income component from TIPS and work backwards to determine how much you will need to invest to reach that target (making some assumptions about inflation). Sample bond ladders and bond ladder calculators are available online, but they do not include the inflation-adjustment aspect of TIPS. A nice example of how to build a bond ladder may be found at http://wpfau.blogspot.com/2013/12/how-do-i-build-tips-bond-ladder-for.html.
For shorter term laddering, you will likely need to buy TIPS through brokers on the secondary market that fill in the gaps in your maturity profile – by definition, you have at least part of a 5-year maturity gap to fill. You have to take into account the accrued interest and market changes since the TIPS were issued – the above website explains the terms you need to know to read secondary market listings properly.
You can achieve similar results in a simpler fashion by investing in exchange traded funds (ETFs) that specialize in Treasury Bonds and TIPS with different maturities. Since the ladders have already been established within these funds, you do not have to worry about finding TIPS that meet your maturity and yield needs on the secondary market.
For tax purposes, it is better to keep these purchases within a tax-deferred retirement account if you can. Because inflation adjustments accrue and increase the face value of TIPS – unlike other bonds – you are regularly taxed on that accrued interest, even though you do not actually receive that interest until maturity (or a component of it upon sale).
Laddering TIPS is a useful way to set up regular inflation-adjusted income over a longer timeframe – but it is important to keep this in the context of your overall portfolio. Investing too heavily in TIPS will deprive you of the higher-return investments and potentially leave you short of the overall retirement funds that you need.