INFLATION-INDEXED Treasury bonds, formally known as Treasury Inflation-Protected Securities, or TIPS, were first sold in January 1997, with the 10-year note initially yielding 3.45 percentage points more than inflation. Unfortunately, yields have been trending lower ever since. They did briefly spike above three percentage points in late 2008. But that rich yield didn’t last long, and 10-year TIPS were offering negative real yields as of year-end 2020.
While the yield on regular 10-year Treasury notes is often depicted as the risk-free rate, arguably that distinction belongs to 10-year TIPS. Not only are you protected against defaults, but also you’re protected against inflation. The principal value of an inflation-indexed Treasury bond is stepped up along with the inflation rate. The semiannual interest payment is then calculated by applying the bond’s rate to this increased principal value. For instance, if inflation runs at 3% and you buy bonds yielding 1%, your annual total return would be 4%. One warning: If you own TIPS in a regular taxable account, you will owe federal income taxes each year on both the interest payments and the step-up in principal value.
Want to get a handle on expected inflation for the next 10 years? Take the yield on regular 10-year Treasurys and subtract the yield offered by 10-year TIPS. As of year-end 2020, the difference was some 2%, an indication of the annual inflation rate expected by investors over the next 10 years.
TIPS can be purchased directly from the government. But you might also check out low-cost mutual funds, such as Fidelity Inflation-Protected Bond Index Fund and Vanguard Inflation-Protected Securities Fund. There are also low-expense ETFs available, including iShares TIPS Bond ETF and SPDR Bloomberg Barclays 1-10 Year TIPS ETF.
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