Currently, the Federal Reserve is trying its best to raise interest rates, but still be accommodative, so that it does not negatively impact global economic growth. The recent volatility of the US stock market can attest to the challenge before them. When, if, and how much the Fed raises rates is perplexing investors everywhere.
However, one obvious and simple theme where we can all be in alignment with the Fed is in its pursuit of increased inflation. For years now, the Federal Reserve has professed worries about deflation and the need to get inflation up to at least its target of 2%. What the Fed wants, it usually gets. In fact, in many cases they tend to overshoot their targets. So how can we team up with the Fed and invest for increased inflation?
One investment alternative is US Treasury Inflation Protected Securities, called TIPS. These are bonds issued by the US Treasury with very unique characteristics. Like regular bonds, TIPS do have a fixed interest rate paid on them. However, it is usually significantly lower than comparable normal bonds. For example, a ten year US bond currently pays about 1.8% in interest a year. But a 10 year TIP pays only .7%. To make up the difference and make the TIP attractive to investors, the US Treasury adjusts the face amount of the bond by a factor based on the Consumer Price Index. If inflation is rising based on the CPI, the TIP will increase in value. The coupon interest rate is then paid on the higher value of the bond.
For example, if you were able to purchase a TIP for $1,000 with a coupon rate of 1% and inflation rose 2%, you would receive $10 in interest plus another $20 in inflation adjustment to the principal. Your bond would now be worth $1,020. Your next interest payment would be calculated on the $1,020 or $10.20. So, in periods of rising inflation, the increasing value of the TIP would compound. TIPS, per the Barclays US Treasury TIP Index, rose on average 9.5% in the four years after the 2008 Great Recession, 3.5% higher than the return on normal bonds. Inflation then dropped over the next three years (oil?), and TIPS had an average negative 1.2% return.
The US Treasury also guarantees that you would not lose any of your original investment. So, if we had a bout of significant deflation as we did in 2008, the US Treasury will still pay you back your $1,000 investment, even if the deflation adjustment dropped the value of the bond to under $1,000.
Disadvantages of TIPS
One of the drawbacks of TIPS is the “phantom income”. As with normal bonds, the interest paid on TIPS are taxable at the federal level but not at the state level. But the inflation adjustment is taxable every year that there is an increase, even though the amount is not paid out to the taxpayer. You do not receive the increase in the bond due to the inflation adjustment until the bond matures. For this reason, many investors like to use TIPS in their qualified accounts, such as IRA’s and 401k’s.
Another concern is a rise in interest rates. Like regular bonds, TIPS’ market value can be affected by changes in the levels of interest rates. If rates rise at a pace higher than inflation, a normal bond becomes much more attractive.
The Federal Reserve, in its recent Federal Open Market Committee meeting, issued the following comments as part of its meeting statement:
“Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.”
“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”
The full statement can be found here.
So if interest rates are expected to remain low over an extended timeframe while inflation is targeted to increase, TIPS can be a valuable addition to your portfolio. If you have any questions regarding Treasury Inflation Protected Securities, please call us at Geier Asset Management.
© Geier Asset Management, Inc. March 2016. Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance.