Financial encyclopedia

Inflation has recently re-emerged as a key focus for markets. The U.S. government issues a special type of Treasury bond designed to hedge against inflation, known as TIPS (Treasury Inflation-Protected Securities).

Interestingly, even when inflation rises, the price of these bonds can still fall, and investors may end up losing money.

If TIPS are meant to protect against inflation, why could they still result in losses?

How do TIPS protect against inflation?  
Regular Treasury bonds have fixed principal amounts, but TIPS differ: their principal is adjusted according to the U.S. Consumer Price Index (CPI).  

For example, if you purchase a TIPS with an initial principal of $1,000 and the CPI increases by 5% over time, the principal will be adjusted upward to $1,050.  

Moreover, the interest payments on TIPS are calculated based on this adjusted principal, so as the principal grows, so does the amount of interest received. In simple terms, when prices rise and purchasing power declines, TIPS help investors mitigate inflation's impact by increasing both principal and income. If held until maturity, the U.S. government guarantees that the repayment amount will not be less than the original face value at issuance.

So if the principal is protected, why might investors still lose money?  
The key lies in the difference between what the government pays at maturity and what the bond’s market price is during the holding period.

Suppose you buy a TIPS when the market demands a real return of about 1%. Later, market interest rates rise, and investors now expect a 3% real return from similar TIPS.  

However, your existing TIPS still pays interest based on its original calculation method. To attract new buyers, the market price of your bond must drop.  

Think about it: if others can now buy similar bonds at more attractive prices, they naturally won’t want to pay your original price for your older bond.  

Thus, even though inflation increases the TIPS principal, if the bond’s market price falls more sharply, selling before maturity could still lead to a loss.

This explains why, despite having guaranteed principal protection at maturity, TIPS don't guarantee no losses when bought or sold at any given time. Especially if purchased above the original principal, even holding to maturity doesn't ensure a profit.

What does this have to do with gold?  
Besides inflation protection, TIPS serve another important purpose: helping investors gauge the U.S. real interest rate (real yield).

Put simply, the real interest rate reflects returns after adjusting for inflation. For instance, if an investment yields 5% annually but inflation rises 3% during the same period, the actual increase in purchasing power is only about 2%.

The market yield on TIPS serves as a crucial benchmark for tracking the U.S. real interest rate.

When the real yield on TIPS rises, it means investors can earn higher real returns from these bonds.  

By contrast, gold itself does not generate interest. As bond yields become more attractive, the opportunity cost of holding gold increases, potentially putting downward pressure on gold prices. This also explains why gold doesn't always rise when inflation heats up.

Of course, gold prices are influenced by many factors—including the U.S. dollar, central bank gold purchases, and safe-haven demand—so real interest rates alone cannot fully determine its direction.

Therefore, when analyzing gold, beyond just monitoring inflation levels, it's worth taking an extra step: determining whether the U.S. real interest rate is rising or falling.