How Investors Face Inflation With TIPS

Inflation hasn’t been a big concern for years, but that can change as the economy gathers steam, causing another worry for investors who need to make a nest egg last for life.

That’s where the Treasury’s inflation-protected securities, known as TIPS, come in. At least, that’s the pitch. TIPS are designed to hold their value even when inflation chews away at other investments. But TIPS are not exactly generous income producers, currently paying only about 1 percent over the inflation rate.

Is the risk of inflation high enough today to justify settling for so little in “real,” after-inflation return?

[See: 10 of the Best Stocks to Buy for 2019.]

Jay Srivatsa, CEO at Future Wealth in Los Gatos, California, says TIPS are attractive in uncertain periods like today.

“Anyone saving for retirement should be looking at loading up on TIPS now, Srivatsa says. “With the market whipsawing every week, Nasdaq in a free fall and no insight into what the Fed will do to interest rates given this backdrop, TIPS with a good yield are a safe bet now.”

TIPS can be purchased directly through the government’s TreasuryDirect website, on the secondary market through a broker or in the form of mutual funds and exchange-traded funds.

Ordinary bonds pay a set coupon rate until the investor’s principal is returned when the bond matures. That makes them appear safe, but inflation can be devastating because those interest payments have less and less value as rising prices eat away at the dollar’s purchasing power. And as inflation takes hold, investors demand higher yields to compensate. That drives down prices of older bonds that pay less.

Investors holding older bonds have a tough choice: hang on until they can receive the bond’s face value at maturity, earning a below-market yield until then, or sell while prices are down to reinvest in something more generous, booking a loss that can wipe out years of interest earnings.

First marketed in 1997, TIPS are meant to solve the problem. Every year the bond’s value is raised to match the inflation rate. The fixed interest rate is then applied against the higher principal.

This can be a life saver when inflation and interest rates are rising fast. But if they don’t the fixed yield can seem pretty skimpy. Currently, fixed yield on the 10-year TIPS is only about 1.1 percent.

Of course, most TIPS investors also own ordinary bonds and stocks, using TIPS as one of the more conservative holdings. So, are TIPS appealing today? Should investors buy, hold or sell?

Ordinary 10-year Treasury bonds currently yield about 3.1 percent, about two points higher than the comparable TIPS. This indicates that investors expect inflation to average about 2 percent over the next decade.

If inflation runs at 1 percent, the ordinary bond would be a better bet, paying 3.1 percent for 10 years while the TIPS would pay 2.1 percent — a 1.1 percent fixed yield plus the 1 percent inflation adjustment. If inflation were to jump to 3 percent, the TIPS would pay about 4 percent, while the ordinary bond would continue yielding a comparatively stingy 3 percent. Currently, inflation is running about 2.5 percent.

[See: 7 ETFs to Buy as Interest Rates Rise.]

“If one is looking for high return, they are not going to get it from TIPS,” Srivatsa says. “But, then, in this market, looking for high return investments is simply asking for trouble.”

Srivatsa recommends a short-term TIPS fund like Vanguard Short-Term Inflation-Protected Securities Index Fund ETF Shares (ticker: VTIP), currently yielding about 3.2 percent. It is not a big moneymaker but has been very stable amid market gyrations due to its focus on TIPS maturing in less than five years. Bonds with longer maturities lose more when interest rates rise.

Michael Tanney, co-founder of New York-based Wanderlust Wealth Management, says TIPS can be especially useful for retirees who need to reduce the interest-rate risk that can cause fixed-income investments to lose value at the worst time, like when cash is needed for living expenses.

“As investors approach retirement, assets are gradually invested in a TIPS strategy that matches the sensitivity of the cost of in-retirement consumption to interest rates and inflation,” he says. “This helps to address the uncertainty of how much in-retirement consumption an investor’s balance can support. It also helps bring greater clarity to assessing retirement readiness.”

Generally, that means buying TIPS that will mature when the investor expects to need money.

Of course, a TIPS investment largely depends on one’s inflation fears, and not everyone believes big fears are warranted today.

Stephan Unger, assistant professor of economics at Saint Anselm College in Manchester, New Hampshire, thinks the Federal Reserve’s hikes in short-term interest rates will succeed in heading off inflation.

“The steady increase in interest rates are starting to harm asset prices, which in turn will lower inflation,” Unger says. “If the Fed keeps on track with its interest hikes, TIPS are in my opinion not the best product to invest in currently.”

For now, he prefers ordinary bonds intended to be held to maturity. Because the investor will receive the bond’s face value at maturity, this strategy overcomes price changes due to interest rate changes.

[See: 9 ETFs for Retirement Investors to Own.]

Investors attracted to TIPS should keep in mind that if the bonds are held in a taxable account both the interest earnings and inflation adjustment are taxable the year they are received, even though the principal gain is not money in the pocket until the bond is sold or matures.

In a period of deflation, the principal can be adjusted downward, but the investor cannot take a tax loss until the bond is sold or matures. TIPS guarantee that upon maturity the investor will receive the original principal paid.

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