If you believe inflation is going to be less than 1.67% over the next 10 years you might want to buy the nominal Treasury bond versus buying TIPS.
If you believe inflation is going to be greater than 1.67% over the next 10 years you would want to buy TIPS instead of nominal bonds.
How To Think About Risk and Reward
I would argue that an embedded inflation rate of 1.67% is so low that risk/reward analysis makes TIPS the overwhelming choice over nominal bonds.
Let’s say I am wrong and the inflation rate is only 0.67% over the next 10 years. Theoretically the investor owning TIPS would lose 1% per year that would have been obtained from buying nominal bonds. But what if inflation is 4%, 8%, over 12% as it was in the late 1970’s? Your reward for owning TIPS instead of the nominal bonds would be enormous.
Fitting TIPS Into Your Asset Allocation
For those investors like myself that believe inflation will be increasing over the next 10 years; TIPS are a conservative approach to having an inflation hedge. There are many approaches to hedging for inflation, but none offer the safety and stability of TIPS.
A careful combination of gold mining stocks and TIPS can provide investors a sound approach to hedging for increasing inflation. For example say you want to allocate 20% of your portfolio to an inflation hedge. A 75/25 split of 15% TIPS and 5% gold mining stocks could be considered to provide such a hedge without taking a large amount of undue risk.
My point is that there are appropriate times and places for TIPS in an investment portfolio. Don’t discard them just because they are considered a conservative investment.
Within a diversified portfolio, TIPS can be combined with other assets to provide protection and stability that no other investment can match.
This article has been republished with permission from Arbor Investment Planner.