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TIPS – Inflation Protection for Your Investment Portfolio

Thursday, April 22, 2010   

Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds that are issued by the U.S. Treasury.  If you’ve never taken a good, hard look at these one-of-a-kind bond investments, now is the time.  Regardless of your financial circumstances or risk profile, there are plenty of reasons to consider adding TIPS to your long-term asset allocation plan.

Benefits of Investing in TIPS

Like other treasury-backed securities, TIPS have virtually zero default risk and are tax-free at the state and local level.  What makes TIPS unique, however, is that they offer a government-guaranteed rate of return above inflation when held to maturity.  When you purchase a traditional bond from the U.S. Treasury, you’re loaning money to the government.  In exchange, you’re promised a fixed schedule of interest payments, and, when the bond matures, a principal payment.  Inflation seriously hurts the lender (you), because as prices rise, your fixed payments are able to buy fewer goods and services.  With TIPS, principal and interest payments are directly linked to the Consumer Price Index, so your investment income rises with inflation, preserving your purchasing power.  Traditional bonds typically have higher yields than TIPS because an inflation expectation is already built in.  For example, if 10-Year U.S. Treasury Notes are yielding 4.5%, and 10-Year TIPS are yielding 2.5%, the bond market is expecting a 2% inflation rate over the life of those bonds.  If you were to purchase the 10-Year TIPS, you would insure your bond against unexpected inflation (i.e., an inflation rate higher than 2%).

TIPS also offer a solid diversification benefit in a portfolio context.  Modern Portfolio Theory tells us that we can enhance our portfolio’s risk-adjusted returns by adding non-correlated asset classes.  Compared to traditional bonds, TIPS have a lower historical correlation with the U.S. Stock Market, based on real and simulated return data from 1972-2009.

Risks of Investing in TIPS

Although TIPS are immune from default risk and unexpected inflation risk, they are still susceptible to changes in interest rates.  As real interest rates rise, TIPS prices fall, making them less valuable.  In addition, as The Finance Buff points out in his new book Explore TIPS, investors should be aware that their personal inflation rate doesn’t always match up with changes in the Consumer Price Index (CPI).  If the mix of food, energy, or health care that you consume differs from the composition of the CPI, TIPS may not perfectly preserve your purchasing power.  Finally, like other bonds, TIPS are inefficient from a tax perspective, so investors should hold them in a tax-sheltered account if possible.

How to Invest in TIPS

Individual TIPS can be purchased directly from the Treasury through periodic auctions or in the secondary market through a brokerage firm.  While owning individual TIPS gives you control over maturity and potentially lower overall expenses, most individual investors will find that the best way to own TIPS is through a mutual fund or ETF.  Owning TIPS in a fund provides maturity diversification, liquidity and easy tax reporting, and there are plenty of low-cost TIPS products on the market.  Vanguard’s Inflation-Protected Securities Fund, VIPSX, is the most popular TIPS fund available, thanks to its low annual expense ratio of 0.25%.

Experts disagree on the best long-term TIPS allocation.  My opinion, generally speaking, is that TIPS should form a sizable portion, but not the majority, of a long-term fixed income portfolio.  Nominal US Treasury Bonds, despite being exposed to unexpected inflation risk, have historically provided a better backstop during major financial crisis.  In 2008, for example, Vanguard’s Intermediate-Term Treasury Fund (VFITX) was up 13.22% for the year, while their TIPS fund (VIPSX) was down 2.85%.  It’s also important to remember that TIPS aren’t the only asset class that provides inflation protection; real estate and commodity-linked securities have historically responded quickly to changes in the price level as well.  Depending on the level of inflation protection provided by other assets in your portfolio, a bond allocation of 25%-50% TIPS seems like a reasonable choice.  Regardless of your financial situation or risk profile, these unique securities deserve to be considered in your long-term asset allocation plan.

Reminder:  Need an opinion on a risk-appropriate asset allocation?  Get a free portfolio recommendation today!

Posted by George | Asset Allocation | Comments (0)
 

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