Inflation Bonds: Are TIPS A Good Investment?
Inflation Bonds: Are TIPS A Good Investment?
Treasury Inflation Protected Securities
As the United States are in the middle of a recession, soaring energy prices have driven consumer prices up at a current annual pace of 5%. According to data released by the Labor Department, its price index increase was the sharpest since June 1982. It should then come as no surprise that as of lately, investor attention has turned to investment vehicles that provide a hedge against inflation.
One such tool is known as TIPS, which stands for Treasury Inflation-Protected Securities; they’re also known as inflation bonds. TIPS provide a simple and easy way for the individual investor to protect their portfolio from inflation. They are one of the most widely known and most effective tools to buy inflation protection for your portfolio.
The reason why protecting yourself against inflation is so important is that in order for your portfolio’s value to grow over time, it has to beat inflation. Let’s say that you have a $250,000 portfolio and manage to make it grow by an average of 5% a year. If inflation, over that same period, averages 3% a year, your real gain is only of 2% a year; and if prices increase by an even 5% a year, after 20 years the value of the money you have will be the same as it is now, no matter how much more money it will have seemed to have turned into. That’s because prices will have been increasing in lockstep with your portfolio’s nominal value.
How TIPS work
The government’s inflation bonds (Treasury Inflation-Protected Securities) are designed to take the inflation equation out of bond investing. They are negotiable bonds issued and guaranteed by the U.S. Treasury with returns that are indexed to compensate bondholders for inflation. Indexing is accomplished by adjusting the principal amount of TIPS upward to adjust for changes in the consumer price index. When inflation is low, this isn’t always the best strategy. But with consumer prices on the rise as they are right now, moving a portion of your fixed-income portfolio into inflation bonds or a TIPS-focused fund can make a lot of sense.
The first TIPS that were made available to the public (in January 1997) have been issued in 5-,10-, and 30-year maturities. Recent issues have been 9 1/2-year and 10-year Treasury notes and 30 1/2-year Treasury bonds. Both pay a fixed-cash interest rate, which tends to be in the 1.5% to 3.5% range. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When an inflation bond matures, you’re paid the adjusted principal or original principal, whichever is greater.
TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.
Where to buy TIPS
You can invest in inflation bonds, when issued, in multiples of $1,000 through Treasury Direct and Legacy Treasury Direct at no cost. You can also invest in them through mutual funds such as Vanguard Inflation Protected Securities fund (minimum investment $3,000) or in variable annuity form through CREF Inflation Linked Bond fund.
Why TIPS are important to have
Says SmartMoney: For example, say you buy at par (face value) a $10,000 10-year TIPS note paying 2% interest. If inflation runs at 3% during the time you own the note (about what people expect these days), your return will equate to a 5% interest rate on a garden-variety Treasury note. And if inflation turns out to be higher than 3%, you’re protected. Why? Because you’re guaranteed to earn 2% on top of inflation. In contrast, people who invest in standard Treasury notes won’t receive anything to compensate them for higher-than-anticipated inflation.
Return on TIPS
According to Investopedia, If U.S. Treasuries are the world’s safest investments, then you might say that TIPS are the safest of the safe. This is because your real rate of return, which represents the growth of your purchasing power, is guaranteed. The downside is that, because of this safety, inflation bonds offer a low return.
Because of the inflation protection, TIPS typically offer a lower rate of interest than other 10-year Treasury securities that don’t have the feature. TIPS are subject to federal income tax, but not state or local taxes.
Tax treatment of TIPS
Once again, SmartMoney sums it up admirably:
Unfortunately, when you hold TIPS in a taxable account, you must pay current federal income taxes on both the cash interest payments and the inflation adjustments to the principal. Even worse, you must pay at your regular income-tax rate, which these days can be as high as 35%. This is especially painful because you won’t actually collect any TIPS principal adjustments until your issues mature or you sell them in the secondary market. Nevertheless, the IRS wants its share right now.
But there’s an easy solution to this seeming tax dilemma: buy inflation bonds only for your tax-advantaged retirement accounts (traditional or Roth IRAs, 401(k)s, Keoghs, SEPs, etc.). That way, the unfriendly tax treatment has no impact, since your TIPS are safely ensconced in a tax-deferred or tax-free account. Putting some TIPS into your retirement accounts makes sense anyway, since for those nearing or in retirement, a main concern is protecting your retirement nest egg against inflation.
Winning Strategy
As with any investment, when trying to balance out your portfolio, you have to weigh risk vs. reward. The “safest” investment out there, the U.S. Treasury bond, offers returns that are steady but not very high. As of July 29, 10-year Treasury notes yielded 4.04% for investors, while 30-year bonds stood at 4.62%. The main problem with this investment is that, while it offers automatic returns, they won’t necessarily beat inflation. For example, a two-year note today yields 2.62% per year. That’s well behind the 5% annual overall inflation rate according to the June consumer price index (CPI). So while as an investor, you can sleep tight knowing that the “full faith and credit” of Uncle Sam is backing your investment, your purchasing power might be taking a hit. Simply put, if you bought a bond today with a 5% yield and inflation averaged 6% over the next 10 years, you’d have a terrible investment.
The jury is out when it comes to buying inflation bonds in general, depending on whether or not inflation is high or not. But as a rule, buying TIPS within your tax-advantaged retirement accounts definitely looks like a sound financial decision.
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