Treasury Inflation-Protected Securities (TIPS) Overview

United States Treasury inflation-protected securities (TIPS) are an easy and effective way to guard against inflation risk, which is one of the biggest risks to fixed-income investments, while getting a real rate of return that is guaranteed by the U.S. government. Because of this, it is important to know how these instruments work, how they behave, and how they can be used in a financial portfolio.

Why Make an Investment in TIPS?

With normal (or nominal) fixed-income investments, investors face the risk of inflation, which means that the buying power of interest payments could drop more than they expected. The Consumer Price Index (CPI) is a measure of inflation. TIPS, on the other hand, are insured to keep up with inflation. This is what makes them different and shows how they act.

To show this, let’s say a $1,000 U.S. TIPS was bought with a 3% coupon and inflation was 10% in the first year. If this happened, the face value of the TIPS would go up by 10%, from $1,000 to $1,100. Also, the 3% bonus payment, which is also based on the face value, would be $33. Payments change every six months and are based on the face value. The result is that not only are interest payments protected against inflation, but so is the bond’s face value, which is refunded to the investor when the bond matures. Neither of these things are protected by traditional nominal bonds.

Because TIPS protect buyers from worries about inflation while nominal bonds don’t, they act differently. More specifically, as people expect inflation to rise, nominal bonds will become less appealing as inflation eats away at future interest payments. In a similar way, when worries about inflation go down (which includes deflation), nominal bonds become more appealing compared to TIPS because future interest payments become more valuable in real terms (after inflation).

Tips on Buying

TIPS can be bought like any other fixed-income investment: straight from the U.S. Treasury, through a broker, or through a mutual fund. If an investor wants to meet specific cash flow goals, it makes sense to buy individual bonds.

The cheapest way to do this is to buy bonds straight from the U.S. Treasury. But if the goal is to get a fully diversified portfolio of fixed-income TIPS, the best choice is a mutual fund, ideally a low-cost index fund.

TIPS Portfolio Development

Fixed income is a very important part of the asset allocation process for investors of all kinds. Keep in mind that over long periods of time, fixed income gives much smaller returns than stocks, but the returns are also much less likely to change. As a result, fixed income helps lower the overall volatility of a portfolio, especially during times of market stress when stocks can drop a lot.

TIPS provide more diversification than nominal fixed income because they remove the risk of inflation for whatever part of the portfolio they make up. Because of this, they tend to have even less risk than nominal bonds, which are worried about inflation. By putting together TIPS and nominal bonds, the fixed-income portfolio and the portfolio as a whole should become less unpredictable.

Tactics

TIPS can be used in different ways, just like any other type of property. TIPS can be used to time the market based on what an investor thinks will happen to inflation. This is similar to buying stocks at a low price or nominal bonds in anticipation of a drop in interest rates.

To do this, you must first know how to figure out the inflation assumption built into TIPS. This is easy to figure out by comparing the yield on a TIPS to the yield on a fictional U.S. Treasury bond. For instance, if a nominal 10-year Treasury bond is priced with a yield to maturity (YTM) of 5% and a similar TIPS is priced with a YTM of 2.5%, the suggested inflation expectation would be 2.5%. With this in mind, an investor could, in theory, buy and sell TIPS at different times based on how he or she thinks inflation will change.

Using the example from above, if an investor thinks that inflation will actually go up to 3.5%, that investor would buy a TIPS because the value of the TIPS will go up if inflation is higher than the market thought it would be. If, on the other hand, a trader thinks inflation will be less than 2.5% or that deflation will happen, he or she will either sell the TIPS they already own or wait for their value to drop before buying more.

But timing the market based on expectations of inflation is no easier than timing the market based on any other investment. Also, remember that the U.S. Federal Reserve can’t predict short-term inflation. Because of this, tactical moves into and out of TIPS should be based on the long run.

To sum up, TIPS can be a great tool for investors who want to get the most out of their risk-reward ratio. Fixed-income investments are an important part of any strategy, and TIPS should be seen as an important part of the fixed-income allocation.

Increase Diversification, Modify Exposure

TIPS should usually be bought through a mutual fund so that you get the most diversity benefits and the right amount of exposure to these assets. Mutual funds that offer active management techniques for TIPS can add value over time, but fixed-income investments have a much smaller chance of adding value than equity investments. Keep in mind that active management is another bet in your portfolio, and it’s an expensive one at that. Index funds are the best way to get into this type of financial vehicle quickly and for less money.

If you want to market-time TIPS, you should keep an eye on the inflation expectations that are already built into the bond markets and change your exposure based on your long-term, not short-term, inflation expectations. Again, this is an area where value can be added over several years. TIPS aren’t nearly as unpredictable as stocks, and their returns aren’t nearly as high. Also, transaction costs can easily outweigh small, short-term changes in the market, so be smart and patient.

The best thing to do with TIPS is to give them a meaningful share of your fixed-income portfolio, say one-third to one-half of the total share of fixed-income investments. Also, there aren’t many ways for active management to add value, so buy a low-cost index fund and stick with it. TIPS are only timed to the market when markets become crazy and expect inflation rates that are too high or too low. Also, remember that the Federal Reserve wants inflation rates to be in the low single digits, and make changes to your assets based on what you think will happen.

Conclusion

If you remember these things, buying in TIPS will be easy and very good for your portfolio. TIPS may not be the most exciting investment, but they are the only ones where the U.S. federal government guarantees a real rate of return. Don’t underestimate how strong this kind of investment can be, especially if you plan to retire someday.