TIPS vs AGG: A Strategic Analysis for Bond Investors - September 2025 

TIPS vs AGG: A Strategic Analysis for Bond Investors 

As an Illinois resident in the 22% federal tax bracket, your choice between Treasury Inflation-Protected Securities (TIPS) ETFs and the AGG aggregate bond ETF represents a fundamental decision about inflation protection versus broad market exposure. After correcting for proper tax treatment, the analysis reveals more compelling advantages for TIPS than initially calculated.

Tax Treatment Corrections and Key Findings

Critical Tax Clarifications: Research confirms that all Treasury interest, including TIPS coupon payments and phantom income from principal adjustments, is exempt from Illinois state income tax. This represents a significant advantage over previous calculations. The IRS treats TIPS phantom income (principal adjustments due to inflation) as taxable ordinary income at the federal level in the year it occurs, even though investors don't receive the cash until maturity.

AGG Tax Disadvantage: AGG contains approximately 40% Treasury securities with the remainder in corporate bonds and mortgage-backed securities. Only the Treasury portion receives Illinois state tax exemption, creating a partial tax benefit compared to TIPS' full exemption.

The Current Investment Landscape

AGG currently offers a 4.38% nominal yield with an effective duration of 6.2 years and moderate volatility of 5.35%. After applying the 22% federal tax rate to the full yield (since Illinois doesn't provide state tax relief on the non-Treasury portions), AGG delivers a 3.42% after-tax return.

TIPS ETFs offer superior tax efficiency with complete Illinois state exemption. Short-duration TIPS (VTIP/TIPX) provide 1.79% real yields with 3.7-year duration, while long-duration TIPS (SCHP/LTPZ) offer 1.77% real yields but carry 11.2-year duration risk.

Scenario 1: Stable Inflation at 2.5%

In a stable inflation environment, the corrected analysis shows TIPS' clear superiority in delivering real returns.

AGG's Performance: With 4.38% nominal yield and 3.42% after-tax return, AGG would deliver only a 0.92% real return after 2.5% inflation. The fund's broad diversification provides yield advantages, but inflation vulnerability remains substantial.

Short-Duration TIPS Advantage: Short-duration TIPS generate 4.29% nominal returns with 3.35% after-tax returns, but most importantly maintain their 1.79% real return guarantee. The tax-corrected analysis shows TIPS provide nearly double the real return of AGG (1.79% vs 0.92%) while offering lower duration risk and volatility.

Long-Duration TIPS Consideration: Long-duration TIPS offer similar real returns (1.77%) with 3.33% after-tax returns, but the 11.2-year duration creates substantial interest rate sensitivity. The risk-adjusted return heavily favors short-duration alternatives.

Scenario 2: Rising Inflation at 3.9%

The higher inflation scenario dramatically amplifies TIPS' advantages, particularly with proper tax treatment considered.

AGG's Vulnerability: AGG's after-tax return remains 3.42%, but with 3.9% inflation, the real return becomes negative 0.48%—guaranteeing purchasing power erosion. This represents the core weakness of conventional bonds in inflationary environments.

TIPS' Inflation Protection: Both short and long-duration TIPS maintain their real return guarantees. With 3.9% inflation, nominal returns increase to 5.69% and 5.67% respectively, generating 4.44% and 4.42% after-tax returns. The guaranteed 1.8% real returns substantially outperform AGG's negative real returns.

Corrected After-Tax Real Returns: TIPS vs AGG Under Different Inflation Scenarios

The corrected chart illustrates TIPS' consistent real return protection across inflation scenarios, while AGG suffers significant purchasing power losses in the high-inflation environment.

Enhanced Tax Implications for Illinois Residents

Complete TIPS Tax Advantage: Illinois' exemption of all Treasury interest from state income tax provides TIPS with a 100% tax benefit versus AGG's partial benefit on only its Treasury component (approximately 40%). This enhances TIPS' after-tax returns significantly.

TIPS Phantom Income Treatment: The principal adjustments are taxed as ordinary income at the federal level, but the Illinois exemption applies to this phantom income as well. While this creates annual tax liability on unreceived income, the state tax exemption partially offsets this burden.

AGG Mixed Tax Treatment: AGG's corporate bond and mortgage-backed security portions receive no Illinois state tax relief, limiting the fund's overall tax efficiency compared to pure Treasury strategies.

Investment Risk Analysis (Corrected)

Duration Risk: Short-duration TIPS offer the optimal risk-adjusted profile with 3.7-year duration compared to AGG's 6.2 years. This provides better interest rate protection while maintaining inflation hedging.

Real Return Certainty: TIPS eliminate inflation uncertainty entirely. AGG faces catastrophic real returns in the high-inflation scenario (-0.48%) while TIPS maintain positive real returns regardless of inflation outcomes.

Volatility Trade-offs: Short-duration TIPS provide 3.03% volatility versus AGG's 5.35%, offering superior risk-adjusted returns. Long-duration TIPS' 8.66% volatility requires careful consideration of the duration premium.

Strategic Recommendations (Revised)

Choose TIPS for Any Long-Term Fixed Income Allocation: The corrected analysis demonstrates TIPS' superiority across both inflation scenarios. Even in the stable inflation environment, TIPS provide 1.79% guaranteed real returns versus AGG's 0.92% inflation-dependent returns—a 94% advantage in real purchasing power.

Prioritize Short-Duration TIPS: VTIP and TIPX offer optimal risk-adjusted returns with lower duration risk, reduced volatility, and identical real return protection. The 3.7-year duration provides better interest rate protection than AGG's 6.2-year exposure.

AGG Only for Yield-Focused Strategies: AGG makes sense only for investors prioritizing maximum current nominal income and confident that inflation will remain consistently below 2.0% for extended periods. Even then, the real return advantage is modest and comes with significant inflation risk.

Illinois Tax Advantage: The complete state tax exemption on TIPS provides material advantage over AGG's partial exemption, particularly meaningful for high-income Illinois residents facing additional state tax burdens.

Conclusion