Over the last several months, inflation has become a hot topic for good reason. We are seeing substantial levels of inflation for the first time in almost 15 years. While it is concerning to see the increasing prices of daily necessities like food and gas, inflation is not a new concept. This year, inflation is on track to average over 5.5% which is significantly higher than previous years. However, in the late 70’s and early 80’s, inflation averaged over 10% per year. With this context in mind, it is also important to note that the Federal Reserve, who is tasked with keeping inflation under control, has announced that they believe that the inflation we are seeing is temporary. They have, thus far, decided to maintain their long-term inflation goal of 2%, meaning they feel confident that inflation will cool down over the next couple of years.
With inflation being a hot topic, we have had several clients ask us about TIPS, or Treasury Inflation Protected Securities. This makes sense since inflation is on people’s minds, and they want a way to mitigate against that risk. In this article we will talk about what TIPS are and explore the main advantages and disadvantages of TIPS.
What Are TIPS?
TIPS, or Treasury Inflation Protected Securities, are a form of government bonds issued by the federal government. They are typically issued in 5-, 10- and 30-year increments. Investors can gain access to TIPS through mutual funds, secondary exchanges, or from the US Treasury directly. Like all bonds, TIPS have a fixed interest rate that is assigned when they are issued. This interest is paid out semi-annually. The unique feature of TIPS is that the par value or principal value of the bond is adjusted based off inflation. This inflation adjustment is based off the CPI (Consumer Price Index) and occurs semi-annually. In times of inflation, this can cause the interest of the bond to increase and thus mitigate the risk of inflation. Let’s look at an example.
Let’s say you bought a TIPS with a par value of $1000 and an interest rate of 2%. If there was no inflation in the first year, you would receive 2 semi-annual payments of $10. If CPI inflation then increased by 5%, your par value would increase to $1050 and the next year, you would receive 2 semi-annual payments of $10.50.
What Are Some Advantages Of TIPS?
- Inflation Protection: TIPS do provide inflation protection for those investors most concerned with inflation. The CPI adjustments that are built in will ensure that the interest that these bonds pay keep up with the rising costs of goods and services as measured by CPI.
- Valuable when inflation is higher than expected: It is important to remember that inflation expectations are already built into bond yields for other government bonds and corporate bonds. Therefore, TIPS will be the most valuable when inflation is higher than anticipated. If inflation is the same or less than anticipated, other bonds may make more sense.
- Conservative: Tips are government bonds and are backed by the United States government. This makes them one of the most conservative investments with very little default risk.
What Are Some Disadvantages Of TIPS?
- Lower Interest Rates: As a form of government bonds, the interest that TIPS pay is significantly lower than corporate bonds. In fact, TIPS typically have an even lower interest rate at issue than other government bonds. So, while the inflation protection might be intriguing, investors may be able to get higher interest from other types of bonds.
- Decreasing interest during deflation: The connection that TIPS have to CPI can actually be a disadvantage during times of deflation. While your original par or principal value is guaranteed, the interest that you receive can actually decrease during times of deflation like we saw in 2008 and 2020.
- Tax Implications: When TIPS are adjusted for inflation, the increase in par value is a taxable event. This can cause a higher overall tax liability as compared to other bonds. For this reason, investors usually invest in TIPS through mutual funds or qualified retirement accounts like IRA’s.
- Price Volatility: While TIPS are usually described as a low-risk investment because bonds are conservative and they have inflation adjustment built in, the price of the bonds can actually be volatile. This is due to swings in demand for TIPS. During times of high inflation, demand can swing upward which drives up the price. However, during times of deflation, demand can fall significantly and drive down the price.
Conclusion
While TIPS can provide some inflation protection to your portfolio, there are significant drawbacks that need to be examined. If you are concerned about inflation and think it might be around for a while, they may make sense in your portfolio. If this is the case, they are best suited inside of your retirement accounts where you can avoid the tax implications of TIPS. Due to their price volatility and relatively low interest, they are better served as a piece of your overall portfolio, rather than a majority of your entire portfolio. Our team believes that a diversified portfolio tailored to your specific goals remains the best overall game plan. Before introducing TIPS into your portfolio, contact your financial advisor and tax advisor to make sure they make sense. If you have questions or want to connect with a member of our team to review your portfolio and discuss further, utilize the links below:
In good health,
Alex