Understanding the benefits of Inflation Indexed Bonds and how they work will help the self-directed investor decide when to buy Treasury Inflation Protected Securities (TIPS).
How TIPS Work
Treasury Inflation Protected Securities (TIPS) are issued and backed by the full faith of the United States Government. TIPS provide protection from inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. At maturity the adjusted principle, or original principal, whichever is greater, is a paid to the holder. TIPS pay interest twice a year at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.
Benefits of TIPS
· Inflation Protection – is the single biggest benefit of TIPS.
· Safety – U.S. Treasury obligations are considered the safest investments in the world.
· Diversification (Non-Correlated Asset) TIPS are an excellent diversification choice because they have little or no correlation with many other investments that are typically in an investment portfolio.
· State & Local Tax Exemption – like other Treasuries, TIPS are exempt for state and local taxes.
· Real Rate of Return – Investors are guaranteed a real rate of return (above inflation) because the fixed interest rate is calculated after the principal is adjusted for inflation.
When to Buy TIPS
When to buy TIPS requires a fairly simple calculation of the embedded inflation expectation in TIPS compared to an investor’s inflation expectations for the time period. The embedded inflation expectation is derived by comparing the TIPS yield to that of a nominal U.S. Treasury bond yield. For example, the yield on a 10 year TIPS is currently 0.72% versus nominal bond yields of 3.17%. Therefore the embedded inflation expectation is 2.45% (3.17% minus 0.72%) over the next 10 years. The current embedded inflation expectation for 30 years is 2.56% (4.31% minus 1.75%).
If you believe inflation is going to be less than 2.5% you might consider the nominal Treasury bond. If you believe inflation is going to be higher than 2.5% you would consider TIPS.
I would argue that the embedded inflation rate is so low that risk/reward analysis makes TIPS the overwhelming choice at this time. Let’s say I am wrong and inflation is only 1.5% (this would be a historically low long term inflation rate) over the next 10 – 30 years. Then theoretically the investor would lose 1% per year that could have been obtained from the nominal bonds. But what if inflation is 5%, 10%, or 13% as it was in the late 1970’s. Your reward for owning the TIPS instead of the nominal Bonds would be enormous.
TIPS in an Asset Allocation Model
As portfolio manager of the Arbor Asset Allocation Model Portfolio (AAAMP) I currently own TIPS, instead of nominal bonds. Because of the Federal Reserve devaluing the currency by printing money; the risk of inflation being higher, possibly, much higher than 2.5%, is very likely.