With Inflation on the Horizon, TIPS warrant a closer look.
There is a lot of talk these days of inflation again rising up to throw a monkey wrench into investment and retirement planning.
While we are not convinced that inflation will emerge as a major problem, there is evidence to suggest that in the short term it could be a factor in deciding on investment strategy and choices.
UBS’s Chief Investment Office issued an alert that “markets are braced for average inflation of 2.6% over the next two years but just 2.2% over 10 years.”
As the world emerges from the Pandemic, lockdowns and recession, look for many companies that have kept a lid on prices to make up for lost ground. Supply chains may also be disrupted fueling inflation.
Not to be overlooked is the concern among some that pumping billions of dollars into the economy for stimulus and other government spending programs could overheat the economy.
With that being said, the consensus among many Federal Reserve watchers is that the Fed will not be raising interest rates, at least in the short term as its main goal is to promote growth and create jobs.
How TIPS Work
The best approach for income investors would seem to be to stay the course but look for ways to minimize any exposure to inflationary trends. One line of defense could be TIPS. These are Treasury Inflation-Protected Securities where the principal is adjusted by deviations in the Consumer Price Index. When inflation and the CPI rise, the principal increases. When the CPI dips in a deflationary environment, the principal decreases.
TIPS pay out interest every six months. Both the amount paid out to TIPS investors when TIPS mature and the interest payments are tied to the CPI. Interest payments rise as inflation increases and decreases with deflation. When TIPS mature, the investor receives the adjusted principal or the original principal, whichever is greater. A “TIPS Inflation Index Ratios” from the Treasury assists the investor to figure out the deviations in the principal from CPI changes.
“On the surface, the Fed’s goal of 2% or slightly higher rate of inflation seems relatively low,” comments Robert Gahagan, senior vice president and senior portfolio manager at American Century. “However, even the
smaller increases in the inflation rate can diminish a portfolio’s power over time.”
Gahagan notes that TIPS offer more effective inflation hedges than commodities and core bonds. In addition, they are less volatile than gold and commodities. Another benefit: as Treasury securities, TIPS are backed by the U.S government and thus have no credit risk.
Another advocate for TIPS especially for retiree portfolios is the well-known investment guru Mark Hulbert. He observes, “no other inflation hedge is guaranteed to rise in lockstep with inflation.”
What’s more, other pundits believe that the market and the Fed are underestimating the true impact on inflation trends. That means that traditional “nominal” Treasuries (provide specific before-inflation returns) and other investments offer no added protection.
The Downside
Despite their vaunted benefits, TIPS are not perfect. Other investments also price in inflation. Standard Treasury bonds have an implicit inflation adjustment.
Say the markets anticipate inflation to be 4% over time, then that expectation is priced into the bond market. Investors make decisions based in part on whether they think inflation will be higher or lower than what the price of a security reflects. That impacts the value of TIPS and standard Treasuries.
The fact is TIPS will do better than Treasury bonds if the stated CPI is higher than what the market anticipates.
The Treasury guarantees that the principal for TIPS will not fall below the original value. But what if deflation occurs. Later, upward adjustments for inflation can be taken back. Therefore, newly issued TIPS offer much better protection from deflation than older TIPS with the same time to maturity.
Another point to consider is that TIPS are not truly a risk-free investment. Price volatility increases risk. Some observers have noted that during the 2008 and 2020 deep stock market declines, TIPs ETFs experienced dramatic price fluctuations. That makes them a more risk-prone investment than cash in the short term.
The investment firm PIMCO points out that Investors who own TIPS through a mutual fund must consider that the fund may perform differently than the actual TIPS securities. “Individual TIPS guarantee an inflation-adjusted return if held to maturity, but there is no guarantee for a fund; a portfolio manager may buy or sell TIPS before maturity, which could lead to gains or losses.”
Still, TIPS could be a worthwhile addition to an investor’s portfolio when income is a goal and inflation could become a concern. Also note that earnings from TIPS are exempt from state and local income taxes just as other US Treasury notes and bonds. TIPS owners pay federal income tax on interest payments in the year they are received and on growth in the principal in the year that it occurs.
The Treasury offers TIPS in terms of 5, 10, and 30 years. US Treasury securities are available directly from Treasury, banks and brokers.
By: Chasing Income
