Treasury Inflation-Protected Securities, or TIPS, may provide investors protection against rising inflation. Inflation is harmful to fixed income for two primary reasons. (1) Inflation eats into the purchasing power of every dollar received from future interest and principal payments, reducing the overall real value of the bond (2) Inflation or generally too much inflation, can cause the economy to overheat, which the U.S. Federal Reserve (Fed) may combat by raising interest rates. Since bond prices and interest rates have an inverse relationship, as rates rise, the prices of existing bonds fall. How can fixed income investors protect themselves against inflation risk?
TIPS are securities issued by the U.S. Treasury whose principal is adjusted by changes to the Consumer Price Index, (CPI) which is the government’s chief measure of inflation. When CPI rises, the principal (think bond price) is adjusted upward, and as CPI falls, price adjusts downward. While principal is adjusted monthly, interest is paid semi-annually at a fixed rate, which is applied to the adjusted principal. (Holders of funds and ETF’s may receive distributions monthly or quarterly) The rate stays the same, but in rising inflationary periods, the amount of interest received is higher, because the rate is calculated off of the new principal. When the bond matures, the Treasury pays the original or adjusted principal, whichever is greater.
There are a couple of downsides to TIPS worth noting. First, inflation protection comes at a cost in the form of lower interest rates compared to standard Treasuries with the same maturity. In fact the spread between the yields on identically maturing Treasuries and TIPS is the bond market’s expectation for inflation over the same period and the “break-even” rate, meaning that if inflation runs above this rate over the life of the bonds, then TIPS would outperform plain vanilla Treasuries all else equal. Second, has to do with taxes. Not only are investors taxed at the federal level on interest income, but also on the increases of principal for the year in which they occur, even if the bond has not yet matured, resulting in investor’s having to pay tax on “phantom income”. Tax laws affecting TIPS mutual funds and ETF’s require that unrealized gains on principal be distributed to shareholders annually, so one advantage is that investors do receive cash directly as they go, but are taxed on distributions in non-qualified accounts.
TIPS may offer a way for investors to hedge against inflation, and provide diversification to the fixed income portion of a portfolio. From a valuation standpoint, TIPS may be undervalued at current levels and could receive a boost if the economy expands. To discuss how TIPS can add value to your portfolio, feel free to contact your advisor, or FinTrust directly at 864-288-2849 or at www.fintrustadvisors.com.
Cliff Hodge, CFA
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