With higher inflation looming on the horizon thanks to the extraordinary increase in the money supply from all the government spending on stimulus and bailouts, many investors are rushing into purchasing “inflation protection” via Treasury inflation-protected securities (TIPS).
How TIPS Work
These securities are essentially government-issued bonds whose principal grows with rising inflation and pay a fixed interest rate every six months, known as a “coupon,” similar to ordinary Treasury’s. But unlike Treasury’s, TIPS are indexed against the Labor Department’s consumer price index (CPI). So when CPI – the measure of inflation – rises, the coupon payments of TIPS and the underlying principal automatically increase.
Conversely, with a fall in the index, or deflation, the principal decreases. But rather than actual inflation, it is the expectation of inflation that drives the demand and price for TIPS. Such expectations could drive TIPS prices higher, thereby shrinking yields, since price and yield move inversely for bond securities.
TIPS are issued via government run auctions in maturities of five, 10 and 20 years. When the TIPS bond reaches maturity, the inflation-adjusted principal is returned to investors. If deflation were to occur, the adjustments to the principal would be negative, though a TIPS bond held to maturity will never return less than its original principal.
For example, assume a plain-vanilla 10-year Treasury currently yields about 1.8%, while a 10-year inflation-protected security (TIP) yields about 0.5%, before inflation. The yield gap between 10-year TIPS and Treasury’s, now about 1.3 percentage points, is called the break even rate and implies an expected annualized inflation rate of about 1.3% over 10 years.
If inflation averages more than 1.3% over the period, then TIPS will outperform standard Treasury’s. The lower the break-even rate is, the easier it is for TIPS to outperform the regular variety Treasury.
Massive Inflows into TIP Funds
So far this year the WSJ reports that nearly $47 billion poured into ETFs and open-ended bond funds with inflation protection as their themes. That is up from $8.3 billion in net inflows during the same period in 2020. That has pushed total net assets in this class of inflation protection funds and ETFs to more than $266 billion.
This popularity in TIPS reflects worries that massive U.S. government spending will eventually lead to high inflation, which could erode the value of stocks and ordinary bonds. Indeed, many TIPS have been bid up to prices exceeding their face value.
The Risks of TIPS
The main risk with TIPS exist in a deflationary or persistent low inflation environment. TIPS typically underperform Treasurys in this situation which means investors risk lower interest payments, and principal loss if they have to sell before maturity; principal loss at maturity is also a risk for investors who bought the security at a premium.
Another risk TIPS holders face is, during periods of inflation, interest rates on traditional Treasurys and other bonds can offer higher yields than what TIPS and their fixed coupons offer because inflation expectations are built into Treasury prices.
Investing in TIPS Directly or through Mutual or ETFs
Buying Individual TIPS Directly: Investors can buy TIPS directly from the U.S. Treasury at TreasuryDirect.gov without incurring brokerage fees; The bonds can also be bought from a bank or broker, which may charge a transaction fee. One downside of buying directly: Gains to the principal aren’t distributed until maturity, although taxes are due annually.
TIPS mutual funds: Actively managed TIPS funds give investors diversification, since the portfolios often hold bonds with various maturities. As with all mutual funds, they charge management fees, although many are low. Gains are distributed to investors’ accounts regularly, instead of at maturity.
TIPS exchange-traded funds: ETFs are index funds that can be easily and quickly traded on an exchange link stocks, a key advantage over traditional mutual funds, which take longer to get in and out of. ETFs typically offer the same advantages as mutual funds, and their fees may be lower. However if you want to make regular contributions without paying fees then a mutual fund is a better way to invest.
There are a variety of funds that invest in TIPS and a handful of exchange-traded funds. Popular TIPS mutual funds are provided by Pimco and Vanguard – e.g. Vanguard Short-Term Inflation-Protected Securities ETF (VTIP). TIPS are historically cheap, yielding a real, after-inflation return nearing 2%. Not a bad return in the current environment for an ultra-safe investment that can protect you against future inflation.
Tax Considerations around TIPS
TIPS are exempt from state and local taxes – but are subject to federal taxes. You’re not buying these for tax efficiency, you’re buying because you’re scared of inflation. Many planners recommend that individual investors hold TIPS in retirement accounts, particularly if the client is in a higher tax bracket.
Another tax consideration to keep in mind: You can defer interest on Treasury bonds for the life of the bond, which means you can earn interest for up to 30 years without paying income taxes on that interest. But the interest on TIPS is taxed every year, so you’re best off holding TIPS in a tax-deferred account like a 401(k) or IRA.
Like any investment TIPS may shield investors from inflationary fears but they can lose value if inflation stays at current low levels longer than some investors expect. Alternative inflation protection investments to TIPS include commodities like gold) and internationally focused equities.