TIPS for Inflation-Proofing Your Portfolio: A Guide to Inflation-Indexed Securities

Treasury Inflation-Indexed Securities, also known as Treasury Inflation-Protected Securities, or TIPS for short, were introduced by the U.S. Treasury to protect principal against inflation.

Are these kinds of investments right for you?

Why TIPS Are Unique

TIPS share a number of characteristics with other Treasury bonds:

• They are backed by the full faith and credit of the United States government and, therefore, have the highest credit quality;

• They are sold at Treasury autions: five-year TIPS in April and October; 10-year TIPS in January, April, July and October; and 20-year TIPS in January and July;

• As with other Treasury securities, interest is paid twice a year;

• Individual investors can buy these bonds directly at auction through the TreasuryDirect program without incurring any commission costs or any cost to maintain their TreasuryDirect account (see www.treasurydirect.gov for more information);

• TIPS can also be purchased in the secondary market, through brokers, with the customary markups.

The distinguishing characteristic of TIPS is that the face value of the bond is adjusted periodically based on the consumer price index for all urban consumers (CPI-U) published by the Bureau of Labor Statistics. Since the CPI-U is announced monthly, there is a lag in the price adjustment of somewhat over one month. Except for this lag, however, over time, the inflation adjustment results in a rise in the face value of the bond at the rate of inflation. TreasuryDirect.gov can help you calculate the adjustment to your principal.

This inflation adjustment also applies to the coupon interest thrown off by TIPS. The interest rate of TIPS is set when the bonds are sold, at auction. That rate never changes. But because the face amount of the TIPS is adjusted at the rate of inflation, interest income rises as the value of the TIPS rises: The interest income computation is applied to a rising base. Note, however, that interest rates at auction vary as the general level of interest rates varies.

TIPS vs. Conventional Bonds

Suppose you are wondering whether to buy a 10-year TIPS yielding 1.93% or a 10-year Treasury note yielding 4.19%. At first glance, the yield of the TIPS appears a good deal lower than that of the 10-year T-note. The conventional 10-year T-note, in fact, appears to have a yield advantage of 2.26% (226 basis points). But remember that the two yields are not equivalent.

The 4.19% yield of the conventional T-note is called the nominal rate. This nominal rate actually consists of two separate components: an implicit inflation rate and an interest rate payment. If you subtract the inflation rate from the nominal rate, the resulting number is what is called the real rate of return of the bond, that is, the rate of return after accounting for inflation. In this example, assuming a current rate of inflation of 2%, you get an estimated real rate of return of 2.19%.

Can you determine, based on these numbers, which is the better buy?

The answer to that is: You don't know and you can't know at the time you purchase the bond. That's because the 1.93% yield of the TIPS does not include the inflation adjustment that will be applied monthly to the price of the TIPS. It may be higher than 2% or lower, depending on the future inflation rate.

In order to compare potential returns of TIPS to those of conventional bonds under different inflation scenarios, analysts have introduced a concept known as the breakeven rate. The breakeven rate is defined as the rate that would result in equivalent total returns for both types of bonds. Using the example above, say the difference between the rate of return of the TIPS and that of the 10-year note is 226 basis points:

• If inflation turns out to equal exactly 2.26%, then the total return of each bond will be equal.

• If the rate of inflation turns out to be higher than 2.26%, the TIPS will turn out to be the better buy due to the inflation adjustment.

• But if the rate of inflation is lower than 2.26%, conventional T-note will turn out to have been the better buy because of higher interest payments during the life of the note.

Of course, at the time you purchase a bond, you cannot predict the future rate of inflation.

Over very long holding periods (10 or more years) the total return of TIPS will parallel the inflation rate. But TIPS will outperform conventional bonds only if inflation is higher than the breakeven rate over these holding periods. Over short periods of time (say one or two years), there is no way to predict which will have a higher total return.

In the event deflation were to occur, TIPS enjoy a measure of protection: The Treasury guarantees that if you hold a TIPS until it matures, its price will not be below the original price of the bond at auction. But while it trades in the secondary market, the price of a TIPS fluctuates on a daily basis, both up and down, and may decline below its face value.

TIPS Mutual Funds

TIPS funds are a very small corner of the bond fund universe.

Returns posted for TIPS funds, like those of any other bond fund, are total returns, consisting of both interest income and changes in net asset value. TIPS bonds, and consequently TIPS funds, are more volatile than conventional bonds and conventional bond funds.

TIPS funds are offered by both load and no-load fund families. Some TIPS funds pay interest quarterly, rather than monthly. The inflation adjustment in the price of TIPS bonds is reflected in daily changes in net asset value. But mutual fund groups may also make periodic adjustments based on inflation adjustments announced by the Treasury.

If you are buying TIPS through funds, investigate no-load funds with low expense ratios.

Taxes

The tax treatment of TIPS resembles that of zero-coupon bonds. The face value of TIPS is adjusted periodically. If you buy a TIPS at auction, and hold it until it matures, the inflation adjustments will not be paid out until you redeem the bond at maturity. But you will be taxed annually on the adjustments. That is sometimes called a tax on "phantom income."

If you hold TIPS in a bond fund, you will also be taxed annually on the inflation adjustments. If you are in a high tax bracket, that feature might make these bonds suitable primarily for tax-deferred or tax-advantaged accounts. Note, also, that income from TIPS is exempt from taxes at the state and local level, but it is taxable at the federal level.

Conclusion

The main attraction of TIPS and TIPS funds is that they provide a hedge against future inflation and insure a modest, but real rate of return over long holding periods.

Any discussion of TIPS, however, has to distinguish between long-term (10 years or more) and short-term holding periods (a couple of years). Over the long pull, the total return of TIPS will track inflation and generate a real rate of return that parallels inflation. Whether that turns out to be higher or lower than conventional bonds will depend on the actual course of inflation versus the expected inflation when a convention bond is purchased.

Over shorter time periods, say one or two years, changes in the price of TIPS are correlated not so much with actual conditions of inflation, as with expectations of inflation, as well as demand. This is true even though actual physical adjustments in price and coupon income occur at all times.

Because of their tax consequences, TIPS and TIPS funds are best held in tax-deferred accounts.

If you plan to invest larger amounts, the most attractive way to invest would be to buy TIPS at auction through the TreasuryDirect program. This enables you to build up a portfolio of TIPS tailored to your needs, while avoiding all commission costs or any management costs of your account.

HOW TIPS WORK

To illustrate how the inflation adjustment applies to a TIPS, suppose that you invest $10,000 in TIPS and the interest rate set at auction is 3%. The first interest payment will be ½ of 3% multiplied by $10,000, or $150.00. Now further suppose that the CPI rises by 1½% during the first six months. The value of the principal will now rise by 1½%. The bond will now be worth $10,150. The second interest payment will be based on the increased value of the bond. It will therefore be ½ of 3% multiplied by the new value of the bond: $10,150 or $152.25. You may look at these numbers and think: "Big deal! A 3% interest rate and minute adjustments to the coupon don't amount to very much." But if you estimate the numbers for a bond with a 10-year maturity, they begin to look a lot more attractive. EXAMPLE CLICK ON IMAGE TO SEE FULL SIZE. Assume, for example, that inflation averages 3% a year over the life of the bond. Over that 10-year period, the face value of the bond (that is, its principal value) would rise to approximately $13,440($10,000 times 3% per year, for 10 years, or $10,000 (1.03)10). Interest payments would also rise gradually throughout the life of the bond. When the bond matures, instead of the $10,000 you invested, you would redeem the bond at its appreciated face value at that time: $13,440. In addition, interest income would rise gradually until, during the 10th year, coupon payments would have increased to about $201.50 twice a year, or $403.00 annually (see illustration above). Total return on that bond would consist of the interest payments you would have received, plus the additional $3,440 adjustment to principal that you would receive at maturity. The entire amount would add up to somewhere between 6% and 7½% annualized return under those assumptions.