A Tip on TIPS…Be Careful

Will US TIPS Protect You From Inflation?
Will US TIPS Protect You From Inflation?

While currently low, inflation is a hot topic these days. It’s difficult not to turn on the television or read a financial blog without hearing about “Federal Reserve Money Printing” and the coming “Hyperinflation.”

Most of these prognosticators are clueless and have been proven wrong on their claims for years now.  This post is not about what the inflation rate will be in the future, instead, it’s about whether or not United States Treasury Inflation Protected Securities (TIPS for short) will protect you if we do have inflation as well as the potential risks involved.

Historically, I’ve been a big fan of US TIPS (See an explanation of TIPS at end of this post), however I’ve become increasingly concerned about holding them and more concerned about people without a financial background holding them.

I’ve witnessed TIPS funds being added to retirement plans (401(k), 403(b) and 457(b)) as participants express concern about inflation, but I’m concerned that they are buying something they don’t fully understand and at a price they may regret.

The term “Inflation-Protected Security” is a bit misleading as their is no guarantee that an investor will earn a return that is even with inflation and there is a possibility one could lose money in both real and nominal terms. Like any security, price matters and the price of TIPS in general seems to me to be overpriced (others disagree).

In a recent blog post by Linda Stern of Reuters (Stern Advice: How Anti-Inflation Bonds Could Smack Investors), she expressed the same concern:

Many mom and pop investors buy Treasury inflation-protected securities (TIPS) in the belief that they are as safe as safe can be: The full faith and credit of the U.S. government stands behind them, and their returns adjust to keep up with inflation.

But here’s a fact that some may find surprising. If interest rates move up faster than consumer prices do, their TIPS investments can turn around and bite them. A low-yielding inflation-protected bond could actually lose value faster than a comparable non-inflation protected bond in that scenario, according to experts like Gemma Wright-Casparius, a TIPS fund manager for Vanguard and Jason Ware, market strategist and chief analyst for Albion Financial Group in Salt Lake City.

“Anyone who believes TIPS are a safe investment is certainly not doing their homework,” he said. “When rates do rise, which eventually they will, there is going to be some pain in TIPS.”

Investors may be pouring money into a product (TIPS bond funds) at precisely the wrong time.   How does one “know” that TIPS are overpriced or that this is the wrong time to buy?  There are rules of thumb that exist, but for every person who believes they are overpriced, there is someone else on the other end of the trade disagreeing.  PIMCO’s bond king Bill Gross is actively buying TIPS (Gross Recommends TIPS).

Contrary to the above quote, interest rates don’t have to eventually rise (though I would generally agree that they will at some point) as those in Japan have found out over the past two decades (their 10 year bond is still yielding in the .60% range). There could still be return left in US TIPS, but my point is a little more subtle – for whatever return is available, do you, the investor understand the risk that is associated with it?

Most investors don’t know that they can lose money in US TIPS, even in scenarios where we experience inflation. The Vanguard Inflation-Protected Securities fund fell in value nearly 12% between May and November 2008, a big drop for investors who think they are in a stable investment option. Recently, Vanguard has produced research showing that shorter dated US TIPS might track inflation better than longer dated TIPS and has come out with a Short-Term TIPS fund.

I don’t know how TIPS are going to perform over the next 12, 36 or 60 months, my gut feeling is that the big returns have already been made. Whether or not you decide to invest in TIPS, it would be in your best interest to understand them and the potential downside.

Scott Dauenhauer, CFP, MSFP, AIF

scott@meridianwealth.com

Short Primer on TIPS

A TIP Bond works differently from a normal bond in that the principal balance increases (or decreases) with the rate of change in the Consumer Price Index (CPI) and the interest rate on the bond will calculated on that new balance.

For example, if a newly issued TIP has an interest rate when issued of 2%, the holder of that bond will receive $2,000 the first year in interest assuming a $100,000 principal investment. If the CPI rises by 5% for that year the principal increases to $105,000 ($100,000 increased by 5%) and the 2% interest rate is calculated on the new principal amount so that the holder is entitled to an interest payment of $2,100.

The current yield on a US TIP maturing in ten years is -.64%. In simplistic terms, this means inflation has to be at least .64% annually for the holder to stay even (no gain and no loss). It also means that the holder is likely going to earn less than the inflation rate over the time period they hold the bond (depending on real rates, the holder could still earn the rate of inflation or more). A similar non-inflation US Treasury bond currently yields 1.94% or 2.6% more than the US TIP and this spread represents the market’s expectation of inflation over the coming ten year period.

If we have 2.6% inflation over the coming decade (and you knew this in advance) a person would be indifferent between holding the US TIP or the US Treasury (non-TIP). If Inflation is higher, holding the TIP wins out, if lower, the non-TIP bond wins.

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