I Have a TIP for You
What is the tip? The tip is about TIPS. Also known as Treasury Inflation-Protected Securities.
TIPS are bonds. Like Treasury bonds, they are backed by the full faith and credit of the US Government.
With a few inflation hawks circling above, investors are wondering if TIPS are a good investment.
Before we consider TIPS as an investment we have to think about inflation. Or we can look to the Federal Reserve and see what they think about inflation.
As much as I love bonds, TIPS are tricky devils to understand.
They are tricky to understand because the value of a TIPS is based on the inflation rate as measured by CPI-U. CPI-U is The Consumer Price Index for all Urban Consumers.
The problem with any index or survey is that the data cannot capture every product or service bought and sold. The index is based on an average.
While you may be experiencing higher prices in some categories not everyone is experiencing higher prices at the same time [1].
Unlike plain old vanilla Treasury bonds, the coupon payment and price of a TIPS is adjusted based on the rate of inflation.
With Treasury bonds the coupon payment and price are based on interest rates.
When we look at the yield of a Treasury bond, inflation is priced into the yield. This is a key distinction between Treasury bonds and TIPS.
The yield on a Treasury bond is called a nominal yield. The yield on a TIPS is called a real yield.
When investors want to know what inflation expectations are 5, 10 or 20 years from now, they look at the difference between nominal yields and real yields.
Here is an example [2]
On May 28th, 2021, the yield on a 5-year maturity nominal Treasury is 0.67% , less than one percent .
On May 28th, 2021, the yield on a 5-year maturity TIPS is negative – 1.78%.
Another way to think about this is to say that the expectation for inflation 5 years from now is close to zero.
The Treasury publishes rates for both nominal and real rates daily [3], [4].
If the coupon/yield on a TIPS is lower than a regular Treasury bond, why would investors buy them?
What concerns some investors ( the hawks ) is sudden and unexpected changes in inflation.
The inflation we are experiencing today is expected inflation.
Expected inflation information comes directly from the Federal Reserve.
I use the minutes from the most recent FOMC meeting as my source. The minutes are available to anyone.
The Fed gives explicit detail on what they expect inflation to be, and what is considered an acceptable rate of inflation [5].
With a TIPS, when inflation goes UP, the principal value goes UP and the coupon/ yield goes UP.
For periods of unexpected inflation, the return on a TIPS may be higher than on a traditional Treasury bond.
What happens if you as an individual investor decide to buy a TIPS?
There is always a little catch and in the case of TIPS it is the way the principal and income are taxed.
With a TIPS, when the principal value is adjusted UP, you pay taxes on the adjusted value.
This means you are paying taxes on “gains” that you have not realized.
At this point you might be saying, why would I ever buy a TIPS ?
My tip is, don’t buy an individual TIPS.
For an individual investor with assets outside of a retirement account they don’t make much sense.
You are better off buying a TIPS mutual fund or ETF.[6]
How should you think about an allocation to a TIPS fund in your portfolio?
Inflation always exists in our economy.
The value of TIPS is unexpected inflation.
The way to use TIPS is to have an allocation that is constant. For example, you might want to invest 3-5% of your portfolio in a TIPS fund and leave it. Like a small insurance policy.
TIPS are not a separate asset class. TIPS are bonds. However, in a period of rising inflation TIPS will perform better than nominal Treasury bonds.
Having a small allocation to a TIPS fund is a way to diversify the risk and return in your portfolio.
Rising inflation implies that interest rates on nominal Treasuries will go up.
And we all know what that means right?
When interest rates go up, bond prices go down!
Bonds Part One – The Modest Economist®
[1] Is it Time to Panic about Inflation ? New York Times
[2] TIPS ETFs Can Help Protect From Unexpected Changes in Inflation | Morningstar
This article mentions low-cost TIPS ETF’s
[3] Daily Treasury Real Yield Curve Rates
[4] Daily Treasury Yield Curve Rates
[5] FOMC Minutes April 28th 2021
This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.
