Inflation is currently running at a miniscule 1 percent or so, and has been unusually low for years. So it’s all too easy to ignore.
But over time, like a 30-year retirement, it can still do a lot of damage. After 20 years, inflation averaging the Federal Reserve’s target of 2 percent would reduce a dollar’s buying power to 67 cents.
For long-term investors, stocks offer some inflation protection because inflation drives up prices companies charge, boosting earnings and share prices. But many people in or near retirement don’t want to have to wait out downturns in the stock market.
Real estate can be an inflation hedge, since prices appreciate over time, but it’s hard to pull cash out of a property on short notice.
Bonds can be badly hurt by inflation, which erodes the value of the bond’s principal and interest earnings, often driving bond prices down.
[See: 8 Great ETFs That Hold ETFs.]
So for investors who worry about inflation there are TIPS — treasury inflation-protected securities, a form of U.S. Treasury bond.
TIPS pay off in two ways. First is a small interest payment fixed for the bond’s lifetime — currently a 0.13 percent coupon for a 10-year bond, according to Bob Johnson, CEO of The American College of Financial Service in Bryn Mawr, Pennsylvania.
Then there is a semi-annual inflation adjustment, a sum added to the bond’s principal to equal to the current inflation rate.
As a result, the bond’s value rises with inflation rather than falling. With 2 percent inflation, a $1,000 bond would be revalued at $1,020 by the end of the year. The fixed-interest earnings go up as the bond’s value rises, because it is applied to a larger base. And when the bond matures the investor gets more back than he paid.
In the case of deflation, or falling prices, the investor gets back what he paid, coming out ahead since prices have fallen.
“This means that in a deflationary environment, investors could actually receive an increase in purchasing power from investing in a TIPS,” Johnson says.
Most other investments, such as stocks, are likely to be hammered by deflation.
[See: 10 Long-Term Investment Strategies That Work.]
Of course, the “real” yield — the interest after inflation — is that small 0.13 percent fixed rate. So TIPS are for preserving money’s buying power, not for getting rich.
“An investor who is concerned with inflation increasing in the future is a primary candidate to invest in TIPS,” Johnson says. “TIPS are a vehicle through which investors can maintain purchasing power.
“Those investors wishing to increase future purchasing power — and that describes most people saving for retirement — need to look to assets with more risk, such as equities, to build wealth,” he says.
Comparing the fixed yield on a TIPS with the yield of a comparable Treasury bond shows what the market thinks inflation will be. “So, if a standard 10-year Treasury is yielding 1.72 percent and a 10-year TIPS is yielding 0.13 percent, inflation expectations are 1.59 percent,” Johnson says.
TIPS with maturities of 5, 10 and 30 years can be purchased directly through the government’s TreasuryDirect system, with minimum purchases of $100. And TIPS can be bought and sold on the secondary market through a bond broker.
If interest rates rise, prices of older, stingier TIPS will fall on the secondary market. So the investor who sells before maturity can lose principal.
Because TIPS trading is tricky, most investors choose mutual funds or exchange-traded funds that hold TIPS, such as Vanguard’s actively managed Treasury Inflation Indexed Securities Fund (ticker: VIPSX).
The fund’s manager, Gemma Wright-Casparius, says a TIPS holding is a good investment for one who believes inflation will be higher than the market expectation described above, but not if one thinks inflation to be lower than expected.
So if you think inflation will be higher than 1.59 percent a year over the next decade, a 10-year TIPS might pay more than a standard 10-year Treasury. If you think inflation will be lower than that, buy the ordinary bond.
TIPS can also reduce volatility in a portfolio that includes stocks and other types of bonds, Wright-Casparius says.
By using a fund, the investor can get exposure to a wide range of maturities, with bonds picked by a pro to minimize risk by maintaining a short duration, which is a measure of how much a bond fund’s value will change if interest rates rise or fall.
“Usually, funds offer more broadly diversified holdings” than an ordinary investor could get by purchasing individual bonds, she says.
Tax issues can be irksome. The inflation adjustment to a bond’s value is considered a taxable income the year it is applied, even though the investor does not get this “phantom income” until the bond is sold or matures. As with most bonds, interest earnings are taxed as income the year they are received. Many investors buy TIPS in tax-deferred accounts like IRAs, to postpone tax until money is withdrawn.
As mentioned, TIPS are not likely to make you rich. But because bond prices rise when interest rates fall, gains may be greater than suggested by paltry TIPS yields. The Vanguard fund, for instance, has returned 6.48 percent over the past 12 months, and an annual average of 4.26 percent over the past decade.
[See: 11 Stocks That Donald Trump Loves.]
Granted, that’s not huge. But with a government guarantee you won’t lose to inflation, it’s a lot better than you’d do with an FDIC-insured savings account. TIPS are for keeping your head above water as the cost of living rises, and though it probably would be foolish to put all your holdings into these bonds, they offer a safe place to tuck away some of the money you’ll need in the future.
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Pros and Cons in Investing With TIPS originally appeared on usnews.com
