TIPS – An Inflation-Proof Investment
By Richard P. Halverson

Inflation is Tough on Investments

We have been through an extended period of relatively low inflation.  Some economists fear we may be on the cusp of a period of higher inflation.  Of course, last year some economists feared we might be on the cusp of a period of deflation.  That is the first problem – inflation, deflation, or stagnant prices?  Who knows for sure?

Inflation reduces the real returns for fixed income investments.  For example, assume your investment pays you $100 every year.  Twenty years ago you might have been able to fill your car with gasoline five times with $100.  Today, however, you can only fill it three times for $100.  (And you might feel the situation is worse if you own a Hummer with a big tank and low mileage.)

Inflation is not good for investors.  Investors who hold bonds and other fixed income investments receive the same interest from the bond every year.  The purchasing power of the interest declines due to inflation as illustrated above. 

Additionally, there comes a time when the original principal of the bond will be paid back.  If the investor originally invested $1,000, he/she receives $1,000 back at maturity.  But once again that $1,000 buys a lot less gas, or medicine, or vacations at maturity than it did originally because of inflation.  Even your fast offering donations should be increasing with inflation.

Stocks are not always a good investment during periods of high inflation, either.  Historically, stocks have tended to appreciate in value during periods of low inflation, thus maintaining the investor’s purchasing power.  However, during periods of high inflation stocks have done poorly. 

For example, the period from December 1968 to December 1982 saw 12 of 14 years with inflation above 4% and 6 years above 8%.  Purchasing power fell by 64%, as measured by the Consumer Price Index (CPI).  During that period the Dow Jones Industrial Averages were almost unchanged, rising from 944 to only 1047.  Adjusted for inflation, the purchasing power of the Dow actually fell from 944 to 382 – that’s a lot of lost purchasing power.

To protect against inflation some investors like to hold real estate, gold, or commodities.  These do work to protect against inflation but all have there own headaches making them inappropriate for many investors.

A Treasury Bond that Protects Against Inflation

For investors who want to hold a safe, user-friendly security and be protected against inflation, the Treasury created TIPS.  TIPS is the acronym for Treasury Inflation Protected Securities.  TIPS are the creation of the U.S. Treasury department, and are designed to protect investors against inflation.

These are treasury bonds and notes.  This means their interest and repayment are guaranteed by the U.S. Government.  Along with other U.S. Government securities, they are considered the safest investments in the world.

Most bonds carry a fixed interest.  If the coupon rate is 5.00%, the bond will pay the investor $25.00 every six months – $50.00 a year for every $1,000 bond the investor owns.  When the bond matures, the investor will receive his/her $1,000 back.

With TIPS, the payments are adjusted every six months to reflect changes in the CPI.  Assume an investor owns a $1,000 TIPS bond with a coupon of 2.00%.  Normally, the investor would receive $10.00 in interest every six months.  Assume, however inflation increased 3.00% in the first six months.  The TIPS would pay $10.30.  The extra $0.30 reflects the increase in inflation.  Assume inflation increases another 3.00% in the next six months.  The interest payment would go to $10.609.

Note:  If the CPI goes down, the coupon payment will fall.  It can fall below the original $10.00 every six months in this example.  This is a risk if the economists that are worried about deflation are correct.

The principal is also protected against inflation.  As inflation increases the par value or payoff value of the bond increases.  Assume an investor buys a TIPS bond with a $1,000 par value.  Let’s say that during the time the investor owns the bond inflation doubles.  When the bond matures the Treasury will pay the investor $2,000 – double the original par value of $1,000.  In this case the bond has an added feature protecting it from deflation.  The payoff value of the bond can not fall below its original value of $1,000.

The Catch

TIPS are easy to buy and own and they work as designed.  There is a catch that is a function of the marketplace.  TIPS pay far less interest than their non-inflation protected treasury counterparts.  For example, the coupon rate on a 10-year TIPS is currently about 1.67%, or $16.70 a year for every $1,000 bond.  The coupon rate on a regular 10-year U.S. Treasury bond today is about 4.12%, or $41.12 interest per bond.  These rates are set by the market place, not the Government.

The difference, of course, is related to the expectation that inflation will rise in the next 10 years.  This will cause the TIPS payments to increase while interest payments on the regular bond will remain constant.  At some point the TIPS bond will make up today’s difference.

In theory the value of both the TIPS and the regular bond are the same today adjusted for all the variables.  Here’s why.  Bond pricing involves complex mathematical formulas that allow for compounding and discounting. Inflation expectations are a key component of these models. 

No one knows for sure what future inflation will be.  However, when millions of investors worldwide meet each day electronically in the huge Government bond markets, their collective expectations for inflation are reflected in the final price at which bonds are bought and sold. 

When the market is in perfect equilibrium, the ultimate value of a TIPS and non-TIPS bond will be identical.  Lower payments today will eventually be offset by higher payments tomorrow.  Generally, the Government markets are in equilibrium. No securities market in the world is as efficient as the U.S. Government bond market.  (Oddball people like me find the complex inner workings of this market, with its enormous size, its sophisticated computer models, its derivative securities, its interrelated arbitrage simply fascinating.  But I assure you we are in the minority.  Most people would rather study dirt.)

So your decision about whether TIPS are right for you can be fairly simple. If one of the two following conditions applies to you, then you should seriously consider using TIPS:

One:  You believe inflation will be higher than today’s conventional wisdom. I said above, “No one knows for sure what future inflation will be.”  The collective wisdom of today’s investors is frequently wrong.  You may have a better guess.  If inflation is higher than the market currently expects, then TIPS are a good buy.  If inflation is lower, then regular bonds are a better buy

Two:  Your circumstances make you especially vulnerable to the risk of rising inflation.  This applies to many people who are going to be on fixed incomes for many years. 

If You Are Interested

TIPS are easy to buy and sell.  You can do so through securities brokers or directly through the Bureau of the Public Debt web site.    You can learn more about TIPS (and other government securities) at this web site. The site will tell you how to open an account and purchase TIPS on-line directly from the government.  It is cheaper than going through your broker.  You can also learn more at the U.S. Treasury’s web site

TIPS are sold in multiples of $1,000.

Interest paid on TIPS is exempt from state income taxes, but it is not exempt from federal income tax.  Further, inflation adjustments to principle are taxable in the year they are made – not in the year the bond is sold.  This means you may have to pay tax on an adjustment that has been made to the bond even though you have not received the cash for the adjustment.

Summary

TIPS are a clever invention that can be useful in the right situation.  They do not provide any free snack.  The current price of the TIPS bond already reflects what the market is expecting for inflation.  But if you are very concerned about inflation for any reason TIPS can play a role in your portfolio.

This article is for information only.  Consult your financial advisor before investing.