Treasury Bills and TIPS: Rate Risk and Inflation Risk

EDUCATION, NOT ADVICE · The example bonds. The yields, spreads and inflation rates in this course are examples, not forecasts. The I bond rates and the 2026 tax brackets are real, and the sources say where they come from. A model script calculates every figure. Full disclosures →

Treasury bills

A Treasury bill matures in one year or less. It pays no coupon. You buy it below face value, and you get the face value at maturity. A $1,000 bill for 182 days at a 4% yield costs $980.44. The difference, $19.56, is the interest.

Because the term is short, the price hardly moves when rates change. The risk is different: when the bill matures, you must buy a new one at the rate of that day.

The state tax benefit

Interest on Treasury bills, notes and bonds is subject to federal income tax, but not to state or local income tax. In a state with a 5% income tax, a Treasury at 4% equals a bank deposit at 4.21%. This simple calculation ignores any federal deduction for state tax.

TIPS

The principal of TIPS goes up with inflation and down with deflation. TIPS pay a fixed rate every six months on the adjusted principal. At maturity, you never get less than the original principal. The Treasury sells TIPS for terms of 5, 10 and 30 years.

Suppose that a 10-year Treasury yields 4.0% and a 10-year TIPS yields 1.8% above inflation. The two are equal if inflation averages 2.16% a year. That is the breakeven inflation rate. If inflation is higher, TIPS win. If it is lower, the normal Treasury wins.

The tax trap

Each increase in the principal is taxable in the year that it occurs, as income. You get that money only at maturity. With 3% inflation, the principal of $1,000 grows to $1,030. You owe federal tax on $30 that you did not receive: $6.60 at a 22% rate. For this reason, many investors keep TIPS in an IRA or a 401(k).

Key points

T-bills have little rate risk, but you must reinvest at the new rate.
Treasury interest is free of state and local income tax.
TIPS follow inflation. The increase in principal is taxable each year.

Definition in the field guide: real returns. Next lesson: I bonds, the inflation bond for savers.

Sources

IRS, Topic 403, Interest Received, for Treasury interest that is exempt from state and local income tax, and for savings bond interest that you can defer.
U.S. Treasury, TIPS, for the principal that follows inflation, the terms of 5, 10 and 30 years, and the original principal as a floor at maturity.
IRS, Publication 550, for the federal tax on the increase in TIPS principal in the year that it occurs.