New Options for Investing in Inflation Protected Securities

If you have been a regular reader, you know that I am a fan of  I-Bonds and Treasury Inflation Protected Securities (TIPS) as a secure retirement investment that is also an inflation hedge. If you can put them in a tax-deferred account, TIPS may work better, if only because you are limited in how many I-Bonds you can purchase in a year. A mutual fund company is now making it easier to benefit from TIPS as an investment using exchange-traded funds.

TIPS Explained

Let’s first review the basics of a Treasury Inflation Protected Security, using the explanation provided by the U.S. Treasury:

Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases.

The relationship between TIPS and the Consumer Price Index affects both the sum you are paid when your TIPS matures and the amount of interest that a TIPS pays you every six months. TIPS pay interest at a fixed rate. Because the rate is applied to the adjusted principal, however, interest payments can vary in amount from one period to the next. If inflation occurs, the interest payment increases. In the event of deflation, the interest payment decreases.

At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation.

To further clarify, consider this example. You purchase a $1,000 TIPS with a ten-year maturity and a 2.5% coupon (nominal interest).  Inflation is running 4% annually. At first, the interest paid on the note would be 2.5% of $1,000, or $25.00. However, the principal on the TIPS note will adjust upwardly on a daily basis, corresponding to the inflation rate. At the end of ten years (maturity), your TIPS note would be worth $1,480 (4% annual inflation compounded over 10 years).  Even though the nominal interest rate on the TIPS note remains fixed at 2.5%, the actual interest payments will increase as the value of the principal increases. Thus, in the tenth year, the annualized interest payment will be 2.5% of the inflation-adjusted principal ($1,480),  which is $37.00. At maturity, the investor who purchased the TIPS note when it was issued for $1,000 will receive the inflation-adjusted principal of $1,480. This is in addition to the interest payments.

TIPS as an Inflation Hedge

The  inflation hedge offered by a TIPS investment can be important because inflation can rise quickly and sometimes without warning. This event creates a significant threat to your retirement portfolio because unexpected inflation may lower returns from more traditional asset categories such as stocks and bonds. Lower market returns and rising inflation can cause significantly lower real returns. TIPS can make real returns more predictable when inflation rises abruptly.

The maturity of the TIPS investment can effect its value, both because of inflation as well as interest rate risk. If interest rates rise when you are holding a TIPS note with a long maturity, the market value of the bond (or a fund holding that bond) can go down. A TIPS investment with a shorter maturity can be less sensitive to interest rate fluctuations.

Investing in TIPS

TIPS can be purchased directly from the Treasury at auction or on the secondary market from a broker. This confuses and worries a lot of investors. Buying TIPS in a mutual fund or exchange traded fund is a lot less complicated. TIPS are sold with 5, 10, and 20 year maturities. The problem has been that there have not been many options in buying a TIPS fund wherein the TIPS holdings have a shorter maturity. PIMCO seems to have solved that problem with some new ETF offerings.

The most significant (in my opinion) new TIPS ETF is the Pimco 1-5 Year U.S. TIPS Index Fund (STPZ) which focuses specifically on the shorter maturity TIPS market. Other TIPS ETFs such as iShares Barclays TIPS Bond Fund (TIP) , the SPDR Barclays Capital TIPS ETF (IPE), and the SPDR DB International Government Inflation-Protected Bond ETF (WIP), are focused on TIPS having intermediate maturities. Many experts believe that the shorter duration bonds will provide better inflation protection with lower interest rate risk. I agree.

The Pimco 15+ Year U.S. TIPS Index Fund (LTPZ) will be launched next month and will focus on long-maturity and long-dated TIPS. These are intended to hedge future spending needs against interest rate and inflation risks..

The Pimco Broad U.S. TIPS Index Fund (TIPS) is also scheduled to go live next month and will offer investors exposure across a full spectrum of different TIPS maturities and dates.

Final Thoughts on Retirement, Inflation and TIPS Investing

I think that every boomer should give strong consideration to owning at least some TIPS or TIPS funds, even if only as part of a retirement emergency fund. If you have the resources and are willing to use TIPS as a retirement safety play, you could use the newer TIPS ETFs as part of a Treasury Ladder.

Photo credit:  Thoth92

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