In nightly news coverage, local stories about prices, and talk radio monologues, rumblings about our nation’s debt crisis are starting to expose fears about massive inflation.
There’s no way to know for sure if incredible price hikes are in store, but if the cost of living is going up, you can use various investment risk management strategies to protect your portfolio from the effects of inflation.
One of these strategies is purchasing securities from the U.S. Treasury called Treasury Inflation-Protected Securities, otherwise known as TIPS.
How Do TIPS Work?
TIPS fluctuate in value in direct relation to the consumer price index (CPI), which measures our rate of inflation.
Here are a few basics on how you can buy TIPS and how they work:
- You can purchase TIPS from the U.S. Treasury online or through your banks or brokers.
- The minimum investment is $100, and units are available in increments of $100.
- You can choose a term of five, ten, or thirty years.
- You have the option to sell TIPS in the secondary market before the maturity period expires.
- TIPS have a fixed interest rate, and they pay out twice a year.
- Unlike other fixed-interest vehicles, your principal goes up and down based on the CPI.
- Due to the inflation protection that TIPS provide, TIPS offer lower interest rates than other similar fixed-rate bonds do.
If we enter into an inflationary period, your principal will increase and your interest payments will increase with it. At the end of the maturation period, you get the principal back plus the increase in value.
But these adjustments work both ways: Your principal and interest payments will both fall during deflationary periods. If the CPI falls before your term is up, you are guaranteed to get your principal back, but will not benefit from any growth.
Downsides of TIPS
As with any investment option, investing in TIPS comes with a few specific downsides:
- Interest payments are fully taxable for the year in which you receive them, since they are paid directly in cash.
- Because of the flexibility and potential for increasing returns, TIPS usually start with comparatively lower interest rates than traditional bonds.
- In a period of zero growth, you’ll be stuck at the comparatively low rate. Moreover, during deflation, your interest payments will fall since they will be calculated off of the downwardly-adjusted principal.
Periods of zero growth are certainly possible, especially with the Fed pulling out all the stops to keep interest rates – and, therefore, inflation rates – very low. For example, when Japan instituted similar policies in the late 1990s, a period of zero growth lasted for about a decade.
Your one piece of protection is that even if the economy experiences deflation while you’re holding your TIPS, you are still guaranteed your original principal amount at the end of the investment period. TIPS are designed such that you’ll receive your adjusted principal or original principal, whichever is greater after the TIPS reach maturation.
How Are TIPS Different from Regular Bonds?
Imagine you purchased a traditional ten-year treasury bond paying 4% on a $1,000 investment. You would earn $40 in income every year, regardless of any changes in the economy, and then you’d receive the principal $1,000 at the end of the ten-year period. High inflation would eat into your returns since your money would be worth less than when you invested it. And if the inflation rate surpasses your 4% interest rate, then your real return would in fact be negative.
If you instead invested in ten-year TIPS that started at only 3.5%, with that same $1,000 your interest payments would start out lower, at around $35. Then, the inflation adjustment would increase or decrease your principal on a monthly basis, which would in turn impact your interest payment. If the rise in the inflation index increased your principal to $1,250, then your new interest payment would be $43.75. As inflation continues to rise, so will your regular payments. Moreover, as long as the economy doesn’t experience deflation, you will also benefit from the upwardly-adjusted principal amount once the bonds mature.
TIPS and Your Portfolio
TIPS can be a valuable hedging tool for your personal investment portfolio, especially if you invest in bonds or other fixed-income securities. You can protect yourself against inflation, without the heightened risk of investments like commodities or precious metals.
With TIPS, you have the backing of the U.S. Treasury, and you’ll receive guaranteed interest payments – though the amount of those payments can decrease during rare deflationary periods. Since inflationary periods are virtually inevitable, it usually doesn’t hurt to have a small percentage of your portfolio allocated in TIPS.
After a period of deflation that saw drastic reductions in prices for goods and services, we’re starting to see signs of inflationary pressure at gas pumps and grocery stores. If you feel the trend over the next five or ten years will be for further inflation, then TIPS can be great addition to your portfolio.
I see TIPS as an attractive bond option for 10-15% of a portfolio, especially considering the pressure created by our increasing deficit and our emergence from a deflationary period. The risk on TIPS is relatively low, and they certainly offer more secure returns compared to other inflationary hedges. I like the fact that they can be sold in the secondary market , which gives them some liquidity, and they can provide you with some additional income.
I suggest purchasing TIPS directly, rather than through an ETF. You need to know exactly what you own and how changing rates impact your investment. ETFs can add a layer of fees and potential risk to your investment.
Have you purchased TIPS, or are you considering other hedges? What portion of your portfolio is in TIPS?