Treasury inflation-protected securities won’t make you rich, and they can be whipsawed by interest rate changes. So why would anyone buy these government-issued bonds?
Because they’re really good at one thing: protecting against the ravages of inflation.
And today, with the economy heating up, unemployment at rock bottom and wages beginning to rise after years of stagnation, investors may wonder if they need some extra inflation protection.
“Inflation is the biggest genuine threat for retirement investors today,” says Dan Danford, a planner at Family Investment Center in Saint Joseph, Missouri, noting that a fresh retiree may face serious inflation sometime in a 30-year retirement. “It is always a threat for long-term investors, but even more right now because inflation has been so tame. Investors have been lulled to sleep on this major issue.”
[See: 7 of the Best Stocks to Buy for 2018.]
Other experts, however, don’t see inflation as much of a worry today, so that money socked away in TIPS would miss out on bigger gains offered by alternatives like stocks.
“I don’t see inflation as a serious threat in the foreseeable future,” says Robert Johnson, principal at Fed Policy Investment Research Group in Charlottesville, Virginia. “Inflation is likely to be in the 2 percent range over the next couple of years as that is the [Federal Reserve’s] inflation target. ”
TIPS are government bonds created in the 1990s as another way for the government to borrow money. But unlike ordinary Treasury securities that pay a fixed sum for life, TIPS payments are tied to the consumer price index. Every six months, the bond’s principal is raised by the most recent inflation rate. The bond’s fixed interest rate is then applied to the new principal, increasing earnings slightly in the short run, and potentially a lot over the bond’s five, 10 or 30-year life. Most important, when the bond matures the investor receives the increased principal, which can be substantially more than was paid years earlier.
Principal can also be reduced during times of deflation, but that is uncommon. And the government guarantees it will return the bond’s face amount upon maturity no matter how severe deflation has been.
TIPS, then, look like a perfect way to preserve wealth and keep up with inflation.
“TIPS aren’t meant to compare with other bonds,” Danford says. “Their sole purpose is to protect purchasing power over time.”
But safety comes at a price: TIPS are not terribly generous. Currently, the “real” return is a mere 0.8 percent on a 10-year bond. That’s the interest rate you would earn on top of the inflation rate. If you paid $1,000 for one of these bonds and inflation ran at the current level around 2 percent, the principal would be adjusted to $1,020 after a year. The 0.8 percent real yield would then earn $81.60 instead of the $80 if the bond were still priced at $1,000.
Investors accustomed to stock market gains might scoff at such a pitiful yield, and fixed-income investors can find plenty of products that pay better.
TIPS turn out well if inflation is high, but not many experts predict a return of the double-digit inflation of the late 1970s.
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“The biggest risk facing investors considering TIPS is the possibility of extended periods of low inflation and subsequently, underperforming other fixed-income securities,” says Craig G. Bolanos Jr., CEO of Wealth Management Group in Inverness, Illinois.
Still, safety is valuable, so TIPS can be useful for a portion of the portfolio that needs to be secure.
“The ideal person to own TIPS is someone simply looking to protect the purchasing power of their portfolio,” Johnson says. “The holders of TIPS will not see their purchasing power grow.”
Like other Treasury bonds, TIPS are guaranteed by the federal government, so there’s virtually no chance of a default.
But investors who might need to pull out their money before the bond matures do face interest-rate risk, just as with most other types of bonds. That’s when interest rates rise and the price of an older bond falls because investors prefer new ones that pay more. If you had to sell your 10-year bond after five years, you might find that buyers would offer substantially less than you had paid, though prices can rise if rates fall.
In fact, TIPS are especially vulnerable to interest rate changes compared to many other types of bonds. The longer the bond has to maturity, the more volatile it is, since investors will live longer with the damage from rising rates, or the benefits of falling ones. The investor can ride out this volatility and receive the full adjusted principal upon maturity, but that could mean living with a below-market yield for years, and missing out on the better returns of alternate investments.
“Holders of Treasury Inflation Protected Securities must understand that the return is calculated on the change in CPI and not the change in interest rates,” says Robert P. Finley, principal at Virtue Asset Management in Barrington, Illinois. “With the market expecting two to three more [Federal Reserve] rate hikes this year there is no guarantee that inflation will increase an additional 50 to 75 basis points. Therefore, these holders of TIPS have to understand that it is likely TIPS will decrease this year unless we see a sudden upward shock to inflation.”
Investors should also consider the tax treatment, since the principal adjustments are taxable in the year they are made even though that increase is not money in the pocket until the bond is sold or matures. Annual tax on this “phantom income” can be avoided by holding the bond in a tax-favored account like a 401(k) or an individual retirement account.
[See: 10 Stocks to Buy for the Stay-at-Home Economy.]
Individuals can purchase new TIPS on the government site or on the secondary market through a broker. But the easiest way is through a mutual fund or exchange-traded fund specializing in these bonds. A fund allows an investor to spread risk among many bonds, and funds pay out interest earnings every month instead of every six.
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These TIPS Help Protect Your Portfolio originally appeared on usnews.com
