Inflation hasn’t been much of an issue in recent years, but investors of a certain age will never forget how prices skyrocketed in the late ’70s and early ’80s. Fortunately, investors worried about future inflation have various ways to offset the risk, like owning Treasury inflation-protected securities, or TIPS.
But these days inflation protection might look like a belt with suspenders. If inflation is low, why bother? After all, the most recently issued batch of 10-year TIPS yields just 0.375 percent on top of the inflation rate, which has been running at less than 2 percent.
One reason for owning TIPS is that inflation could pick up as the economy strengthens. Though not many experts forecast a return to the high inflation of past decades, it could be too late to get affordable protection if inflation did flare up, like buying insurance after your house catches fire. And even modest inflation can be destructive for fixed-income investors.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
Many economists have warned that tax reform package proposed by President Donald Trump will increase federal deficits if they don’t spur enough growth to raise tax revenue.
Holmes Osborne of Osborne Global Investors in Odessa, Missouri, says that inflation could tick up to 3 to 4 percent, making TIPS more appealing.
“Given the fact that TIPS are backed by the government, they can make sense for the right investor,” he says. “You have a security that is backed by the government and you have a good chance of receiving a 3 percent return. The only risk is that the (consumer price index underlying TIPS values) falls, but that rarely happens.”
Investors have various strategies for mitigating inflation risk. One is to avoid floating-rate loans like credit card debt and adjustable-rate mortgages that will charge more if inflation and interest rates go up.
Another is to minimize non-discretionary expenses. Having a home that’s cheaper to support would be a good move if your income loses buying power, for example.
Experts have also long noted that stocks offer a measure of built-in inflation protection. As inflation rises, companies raise the prices charged for goods and services, boosting income and share prices. Of course, inflation also raises labor and materials costs, so stocks don’t offer iron-clad protection. You just don’t know which factors will dominate.
[See: The Best ETFs Retirees Can Buy.]
Inflation is more dangerous to fixed-income investors. If you’re earning virtually nothing in a money market fund, even a modest amount of inflation will turn your gains into losses. More important, rising inflation is usually accompanied by higher interest rates, so older bonds lose value because investors would rather buy newer ones that pay more.
This is where TIPS come in — government bonds that guarantee against loss to inflation. They’ve been around since 1997.
Generally, TIPS pay an interest rate fixed for the life of the bond — five, 10 or 30 years for new bonds, or any period in between if you buy a previously issued bond on the secondary market. But every six months, the bond’s principal is raised to match the inflation rate, or lowered during deflation, which is rare. So the bond value rises with inflation and interest earnings go up as they are applied against growing principal.
TIPS can be purchased directly from the government, bought through a broker or through a mutual fund or exchange-traded fund. The Vanguard Short-Term Inflation-Protected Securities Index Fund, (ticker: VTIP) an ETF that owns TIPS, yields a scant 0.76 percent and has returned an annual average of only 0.59 percent over the past three years. The fund has an expense ratio of 0.05 percent, or $5 per $10,000 invested.
Clearly, investing in TIPS is not a way to get rich. But the chief appeal is protection against loss. Think if it as an alternative to a federally insured bank account — low yield but lots of protection from loss. If inflation ignites and other investments plunge, and the value of bank savings erodes, a TIPS investment that holds steady would look pretty good.
Earlier this year, Morningstar, the market-data firm, looked at TIPS performance in the 20 years since they were created and found TIPS returns had handily beaten inflation during that period. A dollar invested in TIPS in February 1997 would have grown to $2.80 by February 2017, Morningstar said.
Since TIPS prices are governed by supply and demand, the bonds reflect investors’s inflation expectations, and those don’t always match actual inflation.
[See: 7 Dividend Stocks to Watch.]
The bottom line: Nothing provides an absolute guarantee against the ravages of inflation, but TIPS are another tool investors can use to hedge their bets — one with a pretty good track record over long periods.
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TIPS Are a Hedge Against Inflation originally appeared on usnews.com
