Due to fears of rising inflation Treasury Inflation Protected Securities (TIPS) have been the subject of many news articles and blog posts. Investors have been stocking up on this special type of investment in the form of individual bonds and mutual funds. While the idea of a bond that protects against inflation is appealing and the concept seems straightforward it is important to understand how these unusual financial instruments work and the role they should play in a portfolio.
Just like traditional bonds TIPS have a fixed interest rate and are issued in different maturities. Where they differ from traditional bonds is that the principal is adjusted for inflation using the Consumer Price Index. This means that while the coupon rate remains constant the coupon payment will vary. It is important to note that in periods of deflation the principal is adjusted downward making the coupon payment (not the rate) smaller. However, if TIPS are held to maturity the holder will be returned the greater of the inflation adjusted principal or the original principal. The price of TIPS depends on the current demand and the price that is paid affects the yield (the more that is paid, the smaller the yield will be).
A recent article in the Market Watch pointed out that with demand being as high as it is right now short-term TIPS actually have a negative yield. In other words investors who buy short-term TIPS are guaranteed to lose money. Unfortunately, what the author either fails to understand or failed to mention is that while TIPS investors are guaranteed to lose purchasing power (a small percentage each year), they are also guaranteed to lose ONLY that amount. Investors who purchase short-term traditional bonds are at the mercy of inflation. If inflation is low the traditional bond holder will have the superior return BUT if inflation is high (which many people are betting on) the TIPS holder could lose LESS purchasing power than the traditional bond holder.
This post is not meant to encourage people to run out and buy up all the TIPS they can get their hands on but merely to illustrate that even when their prices are high TIPS can still be a good investment. For most people it makes sense to have a percentage of their asset allocation dedicated to TIPS so that in a scenario of high inflation that portion of their fixed income allocation will still do well. Study after study has shown that choosing an appropriate asset allocation and sticking with it is the best long-term investment strategy and that jumping in and out of different sectors will only hurt you in the end. We encourage you to consider incorporating TIPS in your portfolio but don’t try to outsmart inflation by stocking up on them.