The Deficit Backdrop Changes the Calculation
When government borrowing climbs without a clear ceiling in sight, the bond market tends to reprice risk quietly – and right now, Treasury Inflation-Protected Securities are drawing fresh attention from investors who spent the last two years ignoring them.
Why TIPS Are Back in the Conversation
TIPS work by adjusting their principal value in line with the Consumer Price Index. When inflation rises, the principal grows; when it falls, the principal shrinks. Interest payments are calculated on that adjusted principal, which means the real yield investors receive is protected against price erosion in a way that nominal Treasuries simply are not. The structure is straightforward, but the attractiveness of that structure depends heavily on where inflation is heading and what the market currently prices into conventional bonds.
For much of 2023 and into 2024, TIPS underperformed because the market believed the Federal Reserve had inflation under control. Nominal Treasury yields were high enough that investors could collect strong coupons without worrying about inflation protection. The so-called breakeven inflation rate – the spread between nominal Treasury yields and TIPS yields that represents the market’s inflation forecast – compressed, making TIPS look expensive relative to their conventional counterparts. Buyers stayed on the sidelines.
That calculus is shifting. Federal deficits have widened considerably, driven by a combination of mandatory spending growth, interest payments on existing debt, and reduced revenue projections. The U.S. government is now borrowing at a pace that structurally pressures long-term inflation expectations upward. When a government finances spending by issuing large volumes of debt, and that debt is absorbed partly through monetary expansion, the long-run inflationary consequences become harder to dismiss. TIPS buyers are essentially betting that this dynamic will push realized inflation above what nominal bonds currently price in.
Real yields on TIPS – the yield you receive after stripping out inflation compensation – moved sharply positive in 2022 and 2023, reaching levels not seen since before the 2008 financial crisis. That matters because TIPS with a positive real yield actually pay investors above inflation, turning the asset from a defensive hedge into something that also carries a return premium. Positive real yields have historically been one of the strongest arguments for holding TIPS rather than treating them as an insurance product with a drag.
Reading the Deficit Signal
The connection between deficit spending and TIPS demand is not automatic, but the logic holds across several channels. Larger deficits mean more Treasury supply flooding the market. More supply, all else equal, pushes yields higher on nominal bonds. But it also raises the probability that some portion of that debt will be monetized over time, which directly feeds into inflation expectations. TIPS buyers do not need to be certain that inflation will spike – they only need to believe that the risk is underpriced in current breakeven rates.
One useful way to evaluate TIPS is by comparing 10-year breakeven inflation rates against the Fed’s stated target of two percent. When breakevens drop meaningfully below that level – or when fiscal conditions suggest inflation could run above it for a sustained period – TIPS start to look mispriced. Wide deficits raise the floor on where inflation can reasonably be expected to settle, because fiscal pressure on the Fed to keep rates from rising too far becomes a real constraint. A central bank that cannot raise rates aggressively without destabilizing the government’s debt service costs is a central bank with limited inflation-fighting room.
This is not purely theoretical. Japan’s experience with yield curve control showed how fiscal dominance can override monetary policy ambitions. The United States is not Japan, and the dollar’s reserve currency status provides a meaningful buffer, but the directional pressure is real. Investors who hold nominal 10-year Treasuries and bet that inflation will stay near two percent are making an implicit assumption about fiscal restraint that current spending trajectories do not obviously support.
Portfolio construction also favors TIPS at this moment for a specific reason: duration risk. Both TIPS and nominal Treasuries carry duration – the sensitivity of a bond’s price to interest rate changes. But TIPS holders receive compensation for that duration risk in the form of inflation adjustment, while nominal bond holders do not. In an environment where both rates and inflation could remain elevated longer than consensus expects, taking on duration through TIPS is a more defensible position than taking it through nominal bonds at comparable maturities. For investors interested in the broader fixed-income picture, inflation-linked savings bonds have also been attracting renewed interest as CPI data stays stubborn.
Demand signals are visible in fund flows as well. TIPS-focused ETFs and mutual funds have seen net inflows recover after a prolonged period of outflows. Institutional buyers – pension funds, insurance companies, sovereign wealth managers – have structural reasons to hold inflation-linked assets because their liabilities are themselves inflation-sensitive. When real yields turn positive and fiscal risk rises simultaneously, institutional allocation committees tend to respond.
The Trade-Offs Buyers Should Understand
TIPS are not without complications. Their tax treatment creates a specific problem for taxable investors: the annual inflation adjustment to principal is treated as taxable income even though the investor does not receive that cash until the bond matures or is sold. This phantom income issue makes TIPS more efficient inside tax-advantaged accounts like IRAs and 401(k)s than in taxable brokerage accounts. Investors who buy TIPS in taxable accounts without accounting for this can find themselves paying taxes on returns they have not yet collected.
Liquidity is a secondary concern worth acknowledging. The TIPS market is large and generally liquid, but bid-ask spreads can widen during periods of market stress, and the inflation adjustment mechanism means that pricing is slightly more complex than for nominal bonds. Investors who need to sell quickly in a volatile environment may find execution less clean than they expect. For those who can hold to maturity and who structure their tax exposure correctly, the current combination of positive real yields and a deteriorating fiscal backdrop makes a straightforward case – the harder question is whether breakeven rates will move enough, and fast enough, to reward buyers who act now rather than waiting for more obvious inflationary evidence to surface.
