Inflation has been unusually low for the past several years, but it can still have a big impact. Even if the inflation rate hovers around the Federal Reserve’s 2 percent target range, the buying power of a dollar would be reduced to 67 cents over a 20-year period.
To help offset the impact of inflation, some investors may consider buying TIPS — treasury inflation-protected securities. This is a form of U.S. Treasury bond that pays out in two ways:
- Fixed interest payout for the life of the bond
- A twice-yearly inflation adjustment added to the bond’s principal
Note that the interest payments are taxable as income in the year they are received and any inflation adjustments are taxable as income in the year they are applied.
The inflation adjustment is what makes this bond different, because it enables the bond’s value to increase with higher inflation. For example, if you take our 2 percent inflation scenario, a $1,000 bond would be revalued at $1,020 at the end of the first year. This, in turn, would increase the fixed-interest payout. Thus the investor actually benefits from higher inflation; even more so when the bond matures because the investor is paid back more than his initial investment.
TIPS may also benefit the investor in a deflationary environment, because in addition to the fixed interest payout, he or she will also receive the entire initial investment upon maturity. In this way, TIPS are similar to other bonds, but offer an inflation hedge. They are backed by the full faith and protection of the U.S. government, which makes them a relatively low-risk investment.
Since TIPS’ payouts are correlated to the inflation rate, they do not offer tremendous upside opportunity. Rather, they offer a way for an investor’s money to keep pace with inflation instead of losing buying power. Note, too, that when interest rates rise, the price of existing TIPS will fall. This means that, like other bonds, if the investor does not wish to hold the bond to maturity, he or she could lose principal in the resale market.
TIPS are offered through the government’s TreasuryDirect system in 5-, 10- and 30-year maturities, with a minimum purchase of $100. TIPS also can be traded on the secondary market through a bond broker or purchased as holdings in a mutual fund or exchange-traded fund.
Following the presidential election, investor expectations of a pro-business economy led to a sell-off of bonds, but TIPS received close to their biggest inflows since 2002, as investors were looking for a hedge against an increase in inflation. In fact, $1 billion of new money flowed into TIPS in the week following the election.
Please remember that investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. It’s important to consider any investment within the context of your own goals, risk tolerance, investment timeline and the composition of your overall portfolio. You should speak with a qualified financial advisor before making any decisions about your personal situation.