To Your Wealth: Tips for TIPS
After one of the worst years in the bond market, you might scratch your head and wonder why I’m suggesting bonds are still an important component of a diversified portfolio. However, with interest rates closer to their historical averages, we can finally start to earn some reasonable income.
The decline in prices was due to an increase in interest rates as there’s an inverse relationship between bond prices and their yields. New bonds issued today are paying higher rates and older bonds with lower rates can be purchased at a significant discount. For example, a bond purchased several years ago may have been paying 2% but today you could purchase a new bond earning 4%+. To make the old bond attractive to potential buyers, the price is lower than what you’d pay for a brand new bond. If you paid $100 to buy the bond two years ago and it currently sells for $95 today, that’s a 5% loss! The longer the maturity date, the larger the decline.
While this explains what happened last year, let’s fast forward to today where current interest rates are much higher than what we’ve seen in the last 15+ years. As of 11/6/23, the yield on the 10-year Treasury Note was 4.67%. The yield on the 10-year Treasury Inflation Protected Security (TIPS) was 2.25% (see https://fred.stlouisfed.org/series/DFII10 for historical rates). We’ll discuss why there’s a difference soon but it’s important to recognize we haven’t seen these rates since 2008.
What are TIPS?
I want to focus on a particular type of bond which adjusts its value based on inflation. Treasury Inflation Protected Securities (TIPS) have been in existence since 1997 and are typically issued in increments of 5, 10 & 30 year maturities. However, you can purchase older TIPS in brokerage accounts with additional maturity dates (for example, a two year old 10-year TIPS would have a maturity date in eight years).
While the interest rate is determined when the bond is first issued, the actual interest earned and the final value of the bond fluctuate based on inflation and adjusts on a daily basis. The principal amount is increased daily (or decreased in the case of deflation) according to the Consumer Price Index (CPI) published by the Department of Labor.
When comparing TIPS to other types of bonds, it’s important to recognize since future inflation is unknown we don’t know exactly how much we’ll earn. However, we can compare the expected returns with our expectation of future inflation. For example, using current yields of 4.67% on nominal bonds (i.e. not inflation-adjusted) and the 2.25% real yield on TIPS suggests future inflation is expected to be around 2.42% (4.67% – 2.25%). If you think inflation will be lower, the nominal bond would be a better option. However, if you think inflation will be higher than 2.42%, then the TIPS would be better. For example, if inflation is 3% during the next ten years, your TIPS purchase would earn 5.25% (2.25% + 3%).
Why Should You Consider TIPS?
TIPS are particularly valuable if you’re concerned about future inflation or want to preserve the purchasing power of money you have today. For example, if I want to make sure I can buy goods or services that cost $10,000 today, I can buy a $10,000 TIPS that will grow based on inflation between now and when I need the money. Even if the particular item or service becomes more expensive, I’ll be able to buy it (assuming it’s price increases similar to CPI).
As I mentioned earlier, the real yield (i.e. after inflation return) is the highest we’ve seen since 2008. Just a few years ago, the real yield was negative which means you were guaranteed to lose money compared to inflation. Of course, the interest rates on other types of bonds have increased so the breakeven ratio isn’t particularly low but it’s still around historical averages for inflation.
Compared to other supposed “hedges” against inflation such as commodities (think gold or other raw materials) or stocks, TIPS’s values are directly tied to inflation. Their prices are also much less volatile than the alternatives.
What are the Disadvantages?
As with every type of investment, there’s always risks and disadvantages. The fluctuating value of TIPS makes it difficult to predict their future values so there’s less certainty than other types of bonds. Arguably, this is what makes TIPS attractive since those fluctuations are tied to inflation but nevertheless we cannot predict what the bond will be worth upon maturity.
While we’ve primarily discussed inflation (i.e. the increase in cost of goods or services), prices can also experience decreases in the form of deflation. This can result in TIPS’s values declining. This risk is particularly acute with TIPS that are purchased within several years of their maturity.
Ideally, you want to own TIPS inside retirement accounts as the tax reporting gets a bit complicated. The accrued inflation adjustments to the face value are taxable each year even though you don’t receive the proceeds until the bond matures. This “phantom income” can catch people unaware if they don’t understand the taxation of TIPS.
Finally, if you can’t tell already, TIPS are somewhat complicated to understand and include a number of components that aren’t readily apparent at first glance. This is especially true when buying bonds in brokerage accounts as the price may be lower (i.e. a discount) or higher (i.e. a premium) to the face value of the bond. In other words, a $1,000 bond may cost $850 or $1,100 depending on current prices.
Alternatives?
When considering TIPS, it’s worth looking at alternatives to either complement the TIPS in your portfolio or as a reasonable alternative. For example, for smaller dollar amounts, buying Series I Savings Bonds also offer inflation protection without the volatility of prices. Since we don’t know future inflation, it may also be worth holding nominal bonds that pay a higher interest rate without the inflation adjustments.
Just like any investment, whether TIPS are appropriate for you depends on your circumstances and personal investing goals. If you’re interested in learning more, the Treasury Department’s website is useful at https://treasurydirect.gov/marketable-securities/tips/.
