Inflation is defined as the general rise in prices of goods and prices and the fall of purchasing power of a currency over time. When wages don’t grow as fast as inflation, it becomes challenging for the people to meet their needs. Inflation is one of the major issues that affects citizens across the world. Governments are constantly working on measures to protect investors from the impact of inflation.
To prevent the erosion of purchasing power and counter inflation, the US government issues Treasury Inflation-Protected Securities (TIPS), which belong to the category of treasury securities. TIPS adjusts in price to maintain the actual value in case of an inflation hike. These are low-risk investment options as they are backed by the US government. If you wish to learn more about TIPS and its suitability as an investment instrument, do consult with a professional financial advisor who can guide you on the same.
In the light of growing inflation concerns in the US, an increasing number of investors are moving towards the TIPS. But can TIPS help counter inflation and should you invest in them? Read further to find out.
What are Treasury Inflation-Protected Securities?
Treasury Inflation-Protected Securities (TIPS) are government-issued bonds that are linked to inflation. With a hike in inflation, the principal value of bonds increases as well enabling them to generate greater returns than conventional bonds. This feature makes TIPS an attractive option for investors in the face of rising uncertainty.
Investors prefer TIPS as it not only offers protection against inflation but it also pays interest twice a year. The interest rate is fixed and determined based on the bond’s auction. The amount of interest earned varies because the principal is adjusted. In the case of inflation, the principle is increased. When the interest rate is applied to the increased principal, the investors can benefit from higher interest or coupon payments. On the other hand, in the case of deflation, the interest payments can be lower.
Rate and terms
- The maturity period for TIPS are 5, 10, and 30 years, minimum terms (45 days in Treasury Direct).
- TIPS can be held up until maturity or can also be traded before maturity.
- To understand the inflation adjustment done to the principal on previously issued TIPS, one can refer to ‘TIPS Inflation Index Ratios’.
- Interest income and growth are exempted from local and state taxes.
- Interest income and growth are subject to federal income tax.
- The interest-earning period is up until maturity.
- Interest is paid twice a year and varies with adjusted principal.
- The minimum investment for TIPS is $100. They can be bought in $100 increments.
- Maximum purchase – Non-competitive ($5 million) and competitive (35% of offering amount).
At maturity, the investors receive an amount equivalent to the adjusted or original principal, whichever is higher. Individuals who wish to invest in TIPS can purchase them directly from the government using the Treasury Direct system. One can also invest through a TIPS mutual fund or TIPS ETF.
Note: You will have to pay management fees if you choose an inflation-protected ETF or TIPS mutual fund.
How the price TIPS’ is adjusted to combat inflation
Treasury Inflation-Protected Securities are important investment tools because inflation can nullify the returns from fixed-rate bonds. Since the rate of interest on these bonds is fixed, the interest payments may not be able to match the pace of inflation. For instance, if your bond pays 2% interest and prices increase by 3%, you will be incurring a loss from your investment. TIPS cushions the investor against the rising cost of inflation throughout its tenure.
An important point to note with TIPS is that its face value is tied to the official CPI (Consumer Price Index). Higher the CPI, the higher the face value of TIPS. As TIPS makes upward adjustments during inflation, interest payments go up. So, if there is no inflation, the investor will receive a coupon payment equivalent to the principal amount coupon rate. But, if there is inflation in prices, the inflation percentage will be added to the principal, and the resultant will then be multiplied by the TIPS rate.
If there is deflation, the percentage of the principal amount is reduced to get the adjusted principal. This value is then multiplied by the coupon rate to compute the coupon payment. Although deflation reduces the principal, the amount at maturity is always equal to or higher than the original principal. The only chance of receiving an amount lower than the principal is when the investor sells the TIPS in the secondary market before maturity.
But, as good a deal as TIPS sounds, it may not always live up to being the ultimate inflationary asset. Read further to know why.
What are the disadvantages of investing in TIPS?
Treasury Inflation-Protected Securities may seem like an ideal investment instrument that keeps pace with inflation and has the backing of the US government. But there are certain drawbacks of investing in TIPS such as:
- The interest rate is usually lower than other fixed-income bonds (because the interest increases with inflation). This makes them unsuitable for income investors.
- The adjustments made every 6 months are treated as taxable income despite the fact that investors may not be able to cash in the money till maturity or sale.
- While TIPS offer inflation protection, they often yield lower than fixed-rate bonds with similar maturity, despite being more expensive.
- Similar to conventional Treasuries, TIPS is threatened by interest rate risk. They stand a higher risk as compared to conventional Treasuries when interest rates rise. This means that the value of the bond may likely fall if the interest rates increase.
- TIPS volatility is often overlooked. The prices of TIPS ETFs varied vigorously during the stock market crashes in 2008 and 2020. Also, the factoring of inflation rates may decrease the principal significantly if there is a deflationary depression.
- CPI is not an accurate measure of the true inflation rate. TIPS can outperform treasury bonds only if the CPI is higher than market anticipation, which is an unlikely situation.
Comparing breakeven rates of TIPS and conventional bonds
The breakeven inflation rates can help the investors decide whether their portfolio will be better off with TIPS or a conventional treasury. The breakeven inflation rate refers to the rate of inflation at which both instruments having the same maturity period will yield the same inflation-adjusted returns up to maturity. If the real inflation rate exceeds the breakeven rate, it will generate more returns. However, if the inflation rate is lower than the breakeven rate, a conventional bond will offer better returns.
Whether investors choose individual stocks, bonds, ETFs, or mutual funds depends on their risk tolerance, along with their ability to research investments and track their performance continuously. The ideal investment strategy will vary from investor to investor. If you wish to expose your portfolio to TIPS, make a decision based on the amount available, your risk appetite, and your investing goal. Do weigh in the pros and cons of investing in TIPS thoroughly. It is advised that you reach out to your financial advisor before investing.
Use the free advisor match tool to match with an experienced and certified financial advisor who will be able to guide and advise you effectively on TIPS and its suitability as a hedge against inflation and as an investment instrument. Give us basic details about yourself, and Paladin Registry will match you with 1-3 professional financial fiduciaries that may be suited to help you.
Other posts from Paladin Editorial
If you plan to have a financially secure retirement, you must prepare for it in advance. Retirement can...
A Roth IRA is a retirement savings account that allows you to save money on a tax-deferred basis....
The best investment portfolio can help you weather the storm of market volatility and achieve your goals without any digressions....