Should You Invest In TIPS Right Now?
Among all the different types of investments available these days, U.S. Treasury bills, notes, and bonds are the only securities considered risk-free. Given the current volatility stock markets worldwide are experiencing, it’s natural for investors to start thinking about adding treasuries to their portfolios to mitigate the risk. The decision, though, is a bit complex because since 1997 you have the choice of investing in a standard Treasury bond or in a Treasury Inflation-Protected Security (TIPS). Here’s a brief explanation of how TIPS work and when to choose them.
TIPS and Treasury bonds are very similar to each other. Both are issued by the U.S. Treasury in maturities of 5, 10, and 30 years and have fixed interest rates that are paid semi-annually. The biggest difference between them is that a TIPS, as the name implies, provides protection against rising inflation. This is accomplished by adjusting the principal of the bond annually based upon changes in the Consumer Price Index For All Urban Consumers (CPI-U).
It’s easiest to understand by example. Suppose you purchase a $1,000 TIPS with a 2% coupon. You will receive $20 per year in two semiannual payments. Suppose also that by the end of the year the CPI-U has increased by 3%. The principal will be increased to $1,030 and the following year’s payments will total 2% of $1,030 or $20.60. This process repeats each year until the bond matures, at which time you’ll receive the higher principal. A further protection prevents the principal from dropping below the original face value ($1,000) in the uncommon situation where the CPI-U had dropped because of deflation.
At first glance this sounds like a no-brainer. If/when inflation rises you not only get a higher annual payout but you also get more money back when the bond matures. However, consider the following:
- Both treasuries and TIPS are taxed each year on the interest payments. TIPS are additionally taxed on any increase in the price of the principal.
- The principal prices of both types of bonds fluctuate based on prevailing interest rates (which are not necessarily aligned with the inflation rate as measured by the CPI). An increase in rates causes a decrease in the value of the principal and vice-versa. If you are investing in TIPS through a mutual fund or ETF, interest rate fluctuations can impact the value of the fund’s share price on a daily basis.
If you want to add a safe investment such as treasury bonds or TIPS to your portfolio, how do you choose between them? The easiest way is to base the decision on your expectation of future inflation. First calculate the market’s breakeven rate which is simply the difference between the current Treasury bond yield and TIPS yield for the maturity you are considering. For example, as of this writing the 5-year Treasury bond is yielding 2.58% and the 5-year TIPS stands at 0.92%. The breakeven rate is therefore 2.58% – 0.92% = 1.66%. If you believe the inflation rate is likely to rise higher than 1.66% over the next few years then you should invest in the TIPS bond or in a TIPS fund of similar maturity since either would be expected to provide the higher return. Otherwise the Treasury bond (or fund) would be the better investment.
Keep in mind that returns on both TIPS and treasuries right now are pretty low. With so many other types of bonds available for investment, either directly or via mutual funds, diversifying the fixed income portion of your portfolio beyond treasuries is not only valuable but – particularly if you are approaching or are past retirement – even more important that diversifying the equity portion. Remember that even though other bond asset classes may be riskier than treasuries and TIPS, they are still much less risky than stocks.