A tip about TIPS (treasury inflation-protected securities): They’re not as simple as they seem. But with oil prices still above $50 per barrel—a significant factor driving up the prices of many goods and services—it’s worth knowing what TIPS are and how they work. They may be useful for investors looking for protection from inflation.
Championed by Alan Greenspan, former chairman of the Federal Reserve, TIPS were created in 1997 and are one of the most innovative investments the government has given us in quite a while; the principal of a TIPS bond is adjusted each month based on the Consumer Price Index. TIPS haven’t really attracted all that much attention, in large part because inflation has been pretty well under control until fairly recently.
Then in 2005, inflation kicked into a higher gear, thanks to soaring oil and natural gas prices, as well as higher costs for other commodities and for food. The 2005 rate of inflation for the entire year was 3.4 percent, up from 2.7 percent in 2004. In 2006, prices were up again, 3.2 percent. Three years of 3-plus percent inflation adds up; you may have noticed that necessities are costing a little more than they used to.
TIPS are meant to blunt the impact of inflation. Several times a year, the U.S. Treasury conducts a TIPS auction, offering TIPS bonds of various maturities. Individual investors can buy these bonds on a noncompetitive basis from most banks or brokers, or directly from the U.S. Treasury. One of the easiest ways to purchase TIPS is through the U.S. Department of the Treasury’s Treasury Direct Web site . Available in 5-, 10-, and 20-year terms, TIPS are offered in multiples of $1,000 and were paying about 4.7 percent on the principal value of the bond at the time of this writing. That’s well below the current interest rates on conventional Treasury bonds of similar maturity. However, that’s where the inflation factor comes in.
Like regular bonds, TIPS carry a coupon, paying interest twice a year at a fixed rate. But the payments vary because the interest rate is applied to the principal after it has been adjusted by the Consumer Price Index. The principal value is adjusted each month, increasing as inflation goes up or decreasing as inflation declines. When a TIPS bond matures or when it is cashed in, the investor is paid the adjusted principal or the original principal, whichever is greater.
Inflation Correlation
“TIPS represent one of the purest forms of inflation hedges there are,” says Wan-Chong Kung, who manages several U.S. government bond funds for U.S. Bancorp’s First American Fund family. “Traditionally, investors have looked toward hard assets, such as real estate and commodities—and, to a lesser extent, stocks. But TIPS tend to have a better correlation with inflation than most of those other assets.”
Kung counsels investors to look at TIPS from two points of view: tactical and strategic. On a tactical or cyclical basis, she says, TIPS are a good way to address financial goals that are sensitive to inflation, such as saving for a college education or saving for retirement in the not-too-distant future. Strategically speaking, TIPS can help to diversify a portfolio.
“TIPS have compiled a track record of low correlation of returns with other types of bonds, and low to negative correlations with both domestic and international stocks,” Kung says. When one investment has a low or a negative correlation to another, it means the two don’t move in the same direction at the same time. This is a good thing—especially when one of those investments is going down in value.
But no investment is perfect, and no investment is perfect for everybody.
While TIPS are designed as a hedge against inflation, investors must be cautious, Kung says. The principal of a TIPS bond can decrease when interest rates rise. To the degree that the upward move in rates is driven by higher inflation or inflation fears, the inflation adjustment on TIPS mitigates against the loss in principal value. Also, like other bonds, TIPS are subject to market volatility. The longer the maturity of a bond, the more its price can vary with changes in interest rates.
On an individual basis, TIPS have to fit your tolerance for risk, your total portfolio composition, your investment objectives, and your time horizon, among other things. So once again, nothing’s simple—not even inflation.
