WORRIED ABOUT inflation? You might be drawn to inflation-indexed Treasury bonds—officially known as Treasury Inflation-Protected Securities, or TIPS. These bonds protect you from unexpected inflation, plus there’s no risk of default.
Those features make TIPS attractive to investors who are concerned about rising consumer prices, and especially the impact of inflation on the bond portion of their portfolio. Intrigued? Before you invest, here are six factors to consider:
1. Hedging vs. speculating. TIPS can be used to hedge against inflation or to speculate on it. Most investors want to hedge inflation, so let’s focus on that.
The total return from TIPS has three elements: inflation adjustments to each bond’s principal value, the interest payments you receive and price fluctuations in the secondary market. Those price fluctuations represent a fly in the hedging ointment—because TIPS prices are volatile. Why? The volatility stems from supply and demand issues, changes in inflation expectations and real yields, speculative buying and selling, and periodic “liquidity events” that increase the appeal of Treasury bonds.
To hedge inflation with TIPS, your best bet is to buy individual TIPS and hold them to maturity. This removes price changes from the equation. But if you buy individual TIPS and sell them before maturity, or if you buy a TIPS fund, you’re exposed to price changes. Falling prices could wipe out inflation adjustments to the principal value of TIPS—which means they fail to provide the inflation hedge you were hoping for.
You also need to know how to buy individual TIPS. They can be purchased at Treasury auctions or in the secondary market. You’ll likely want to buy TIPS with maturity dates that match the goals you’re looking to fund. Be warned: An inflation-indexed Treasury with the right maturity may not be available.
Finally, you need to understand how TIPS are taxed if you hold them in your taxable account. Hint: It’s complicated.
3. Hedging comes at a price. TIPS protect investors from the adverse effects of high inflation, but at a cost. What cost? TIPS offer lower expected real yields than fixed-rate Treasury bonds of a similar maturity. Real yields are the return from an investment, adjusted for the effects of inflation.
Expected inflation is priced into nominal, fixed-rate bonds. Still, holders of these bonds are exposed to the risk that inflation turns out to be higher than expected. By contrast, holders of TIPS have no such worries: They’re protected against unexpected inflation because their bonds’ principal value will be adjusted along with inflation. The upshot: Nominal bonds are priced to deliver higher real yields than TIPS, because nominal bondholders demand to be compensated for taking more inflation risk.
Moreover, TIPS are expensive right now. In fact, their real yields are negative. This should give you pause. It means you’re only partially protected against future inflation. Also, the total return from TIPS could be negative if future inflation adjustments aren’t large enough to offset today’s negative real yields.
Finally, there’s deflation—the danger that sluggish economic growth causes consumer prices to decline. If there’s deflation, TIPS will always mature at their face value, providing some protection. Even so, you need to pay attention to deflation. Why? If you buy secondary market TIPS, their prices will reflect inflation adjustments since their issuance date. If deflation occurs after you purchase bonds in the secondary market, your principal value will fall along with declining consumer prices (though, again, it won’t fall below face value). A loss of principal value, coupled with negative real yields, would make for an expensive hedge.
4. Asset location is tricky. Holding individual TIPS in taxable accounts is problematic. Why? Each year, you have to pay tax on the inflation-driven principal adjustments, even though you don’t receive that value in cash until maturity. TIPS tax compliance is also tricky.
Holding TIPS in tax-deferred retirement accounts makes more sense. Problem is, TIPS aren’t subject to state taxes, and you lose that advantage if you hold them in a retirement account, plus not all 401(k) plans offer a TIPS option. Meanwhile, holding TIPS in Roth accounts may not be the best use of your Roth, where you might want to invest in stocks to take full advantage of a Roth’s tax-free growth.
5. TIPS may test your patience. Why? They’re a low-yield, high-volatility security. That’s a tough combination. Staying the course if TIPS prices fall precipitously could be psychologically challenging.
6. TIPS might be unnecessary. The Federal Reserve has done a good job of controlling inflation in recent decades, which suggests it may now have the knowledge and tools to prevent high inflation. Moreover, the stock component of your portfolio could provide the longer-term inflation protection you need, even if stocks prove to be a lousy inflation hedge in the short run.
Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. His previous articles were Give Me Five and To Roth or Not.