Treasury Inflation-Protected Securities - Need a Tip on TIPS?
By Ric Edelman
With many investors worried about inflation, attention has focused on Treasury Inflation-Protected Securities, government bonds whose profits are based on future levels of inflation. Here’s a primer.
TIPS are issued in maturities of five, 10 and 30 years; the minimum investment is $100. You can buy TIPS from brokers or directly from the government. You can also purchase mutual funds and exchange-traded funds that invest exclusively in TIPS. The following refers to buying individual TIPS.
Every six months, the value of your principal rises or falls based on changes in the Consumer Price Index (the nation’s official measurement of inflation). If inflation has occurred, your principal increases; if prices have declined, your principal goes down. Whatever its value, you receive your principal back at maturity. Thus, it’s possible to lose money from this government-guaranteed security if you sell prior to maturity.
When you buy TIPS, you receive a stated interest rate for the life of the security. However, the amount of interest you actually receive will rise and fall, because you earn interest only on the current principal value. Thus, if deflation has caused your principal to decline, you’ll earn interest on a smaller amount than before.
Fears of inflation have increased demand for these securities; investor purchases of the iShares Barclays TIPS Bond Fund were up 91% for 2009, as of December 1, according to Bloomberg. This means that TIPS investors are actually hoping for massive inflation — otherwise they won’t earn anything.
And if deflation occurs, they could actually lose money if they sell their TIPS prior to maturity.
Suppose inflation does occur. Will TIPS prove to be an effective hedge? Frankly, no one knows. TIPS are new — they were introduced only in 1997 — and we haven’t experienced an inflationary period since then. So how TIPS will actually perform during an inflationary period is largely theoretical. For instance, should inflation occur, the Federal Reserve Board could raise interest rates more quickly than inflation rises. That would increase the yield offered by new bonds, possibly making them more attractive than TIPS.
Also consider the matter of lending money to an entity that decides how much it’s going to pay you back. The federal government, after all, strongly influences inflation and interest rates, and actually controls how the CPI is calculated. Therefore, the feds can change the CPI formula to alter the principal value of TIPS and how much interest it must pay. (They have made such changes in the past, you know.)
Because inflation is not a factor in the economy and there is no proof that TIPS will serve as an effective solution if inflation does become a problem, we are not currently recommending these securities. Circumstances could change, of course, and that is why we continually evaluate the marketplace. But for now, our tip is to avoid TIPS.
From the January 2010 Inside Personal Finance