November 10, 2015
by Michelle Perry Higgins
Many financial experts believe that Treasury inflation-protected securities, or TIPS, are an all-weather investment that every investor should have in their portfolio. However, as we have seen over the last few years, officially calculated inflation has stayed low in spite of forecasts by some prognosticators that the actions of the Federal Reserve would send inflation soaring.
So, if an investor does not have TIPS currently in their portfolio, should they buy now?
When TIPS are issued by the Treasury they come with an interest rate that doesn’t change, like most bonds. The inflation protection works through increases in the principal value of the bond to which the fixed rate is then applied. Increases in the principal value of the bond are tied to increases in the Consumer Price Index. It should be noted that if the CPI decreases as with deflation, then the value of TIPS could decrease as well so that the interest amount received by the investor would also decrease. History suggests that deflation is rare although not totally unprecedented (See the Great Depression). However, on maturity the investor receives at least the original principal value of the bond so downside risk is ameliorated.
While TIPS may a help against inflation, the story does not end there. TIPS do not guard against increases in interest rates unless rising rates are accompanied by increasing inflation. While this has often been the case, there is no assurance that this will always be true. Another issue is with TIPS held outside of retirement accounts. The increase in principal that occurs with an increase in inflation must be reported as income for tax purposes–even if the TIPS is not sold. This is the phenomena of “phantom” income – tax without the corresponding income to pay for it.
Because TIPS protect investors from inflation, they have a lower interest rate than other Treasury securities that have no inflation adjustment. So if we look at the difference between the yield on a 10-year Treasury bond and a TIPS bond of the same maturity, the difference gives a rough measure of market expectations for average inflation over that period of time. For example, if the 10-year Treasury currently has an interest rate of x% while a similar maturity TIPS has a rate of y% we might imply that expected inflation is x – y%.
So, regardless of what TIPS yield now, it could be a good idea to purchase TIPS as part of your bond allocation if you believe future inflation will be higher than expected inflation–and if you are comfortable with the caveats mentioned above.