Treasury Inflation Protected Securities (TIPS) provide benefits that are unavailable with any other investment. We’re going to explore how TIPS work, their benefits, and when it makes sense to buy and hold them in a portfolio.
How Treasury Inflation Protections Works (TIPS)
Treasury Inflation Protected Securities are bonds issued and backed by the full faith of the United States Government.
TIPS provide protection from inflation because the principal of a TIPS bond increases with inflation and decreases with deflation, as measured by the Consumer Price Index.
At maturity of a TIPS bond the adjusted principle, or original principal, whichever is greater, is paid to the owner. TIPS pay interest twice a year at a fixed rate. The fixed interest rate is applied to the adjusted principal; so, like the principal, interest payments rise with and inflation and fall with deflation.
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Benefits of TIPS
This is the single largest benefit and the differentiating feature that would cause one to include TIPS in their portfolio.
U.S. Treasury obligations are considered the safest investment in the world.
Diversification
TIPS are an excellent diversification choice because they have little or no correlation with most other investments that are typically in an investment portfolio. Combining them with riskier inflation hedges can be beneficial to a portfolio.
State and Local Tax Exemption
Like all Treasury securities (i.e. bills, notes, bonds), TIPS are exempt from state and local taxes.
Real Rate of Return
Investors are guaranteed a real rate of return because the principal is adjusted for inflation. In other words, if the bond is held to maturity the investor knows he will receive his stated interest percentage (real return) plus the adjustment for inflation.
Implied Inflation Expectations Calculation
There is a simple calculation that will provide you with the implied inflation rate embedded within Treasury Bonds. You can do this with any maturity but I’m going to use the 10 year bond rates.
Implied Inflation Expectations Calculation:
Treasury Yield Rate (nominal bond rates) – (minus) Treasury Real Yield Rates (TIPS)
= Implied Inflation Expectations
You can find the current rates here:
- Treasury Yield Curve (Nominal Rates)
- Treasury Real Yield Curve Rates
Example calculation:
10 year Treasury Yield = 2.17%
10 year Treasury Real Yield = 0.50%
2.17% – 0.50% = 1.67%
This tells you the embedded expected inflation rate for the next 10 years is 1.67%
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.