Artykuły

Investing in Treasury Inflation-Protected Securities (TIPS)

0

The Federal Reserve aims for an average annual inflation rate of 2%. But they don’t directly control the value of the dollar or the price of goods and services, and inflation sometimes leaps unexpectedly. Inflation dilutes the value of your retirement savings — and all other savings for that matter.

That’s precisely why you shouldn’t just park all your money in a savings account. Instead, you can protect against inflation by investing money to earn a return higher than the pace of inflation. In the wake of the COVID-19 pandemic and the massive “printing” of new money to spend on stimulus measures, many investors have looked for inflation-proof investments to avoid a post-pandemic drop in the dollar’s value.

One of these strategies includes unique U.S. Treasury bonds called Treasury Inflation-Protected Securities, or TIPS for less of a mouthful.

What Are Treasury Inflation-Protected Securities (TIPS)?

Treasury Inflation-Protected Securities fluctuate in value specifically based on inflation rates. The Treasury ties their value directly to the Consumer Price Index (CPI), which measures inflation.

You own shares of Apple, Amazon, Tesla. Why not Banksy or Andy Warhol? Their works’ value doesn’t rise and fall with the stock market. And they’re a lot cooler than Jeff Bezos.
Get Priority Access

Like other Treasury bonds, they’re backed by the federal government, and you buy them at a fixed interest rate. These bonds pay interest (coupon payments) twice per year based on a fixed rate. You receive an interest payment based on that interest percentage of the principal amount — the value of the bond. 

Because the principal amount changes along with inflation, so too do the amounts of the semiannual payments.

How TIPS Work

The face value of a TIPS bond rises and falls based on the inflation rate. The higher the rate of inflation, the greater the jump in the value of the bond. But these adjustments work both ways: your principal and interest payments both fall during deflationary periods. If the CPI falls before your term is up, you are guaranteed to get your principal back, but will not benefit from any growth.

Because TIPS adjust in principal value — unlike normal bonds — they generally pay lower interest rates than normal Treasury bonds.

The Treasury issues TIPS at five-, 10-, and 30-year maturities. You can buy them new, directly from the Treasury, in increments of $100. Or you can buy them from other investors on the secondary market through a brokerage account like SoFi Invest.

For that matter, you can also buy them securitized as exchange-traded funds (ETFs) or mutual funds. These funds make TIPS easy to buy or sell instantly, but prices gyrate based on the market.

Example

Confused yet? Don’t fret — TIPS work differently than normal bonds, which makes them hard for many investors to wrap their head around. An example helps clarify how they work.

Say you buy $1,000 in TIPS that pay 1% interest. In the first year, you receive $10 in interest (1% of $1,000), split into two semiannual payments of $5 apiece.

Over the course of that first year, inflation runs at 2%. So the face value — the principal amount — of your TIPS adjusts upward 2% from $1,000 to $1,020 at the end of that year.

In the second year of ownership, you collect 1% of the new principal amount of $1,020. That comes to $10.20, again split into two semiannual payments, this time of $5.10 apiece.

At the end of that second year of ownership, the principal amount adjusts again, based on the inflation rate that year. If inflation jumps by 4% that second year, your principal amount adjusts upward to $1,060.80. For the following year, you collect interest payments equal to 1% of $1,060.80, or $10.61 total.

And so on, until the bond matures.

You can sell your TIPS bonds on the secondary market if you like. Or you could keep them until their maturity date, and receive the final adjusted principal amount back.

Pros & Cons of TIPS

These funky Treasury bonds come with unique advantages and disadvantages. Make sure you understand them before plowing your money into them. 

Pros

Why do people invest in TIPS? 

  1. Always Beat Inflation. No matter how hot inflation runs, money invested in TIPS always grows faster. That may not mean much during normal periods of 2% inflation, but when inflation blazes at 9% (like we saw in 2022), many other higher-risk investments fail to keep up. 
  2. Inflation-Adjusted Interest Payments. Not only does the bond pay out an inflation-adjusted face value when it matures, but you also collect inflation-adjusted interest payments in the meantime. For retirees worried about inflation eating into their nest egg and investment income, TIPS can offer some reassurance. 
  3. No Principal Risk. In the (unlikely) event of sustained deflation, you’d still get a minimum of your original principal investment back when the bond matures.  
  4. Virtually No Default Risk. I mean, sure, a zombie apocalypse could wipe out the U.S. government and make your TIPS worthless. But short of that, the U.S. government has virtually no credit risk. (And if the U.S. government collapsed, you’d have bigger concerns than your debt securities.)
  5. Exempt from State & Local Income Taxes. The IRS charges you taxes on your interest and principal gains from TIPS, but they’re exempt from state and local income taxes. 

Cons

Beating inflation is great and all, but isn’t there more to investing? 

  1. Low Interest Rates. TIPS typically pay a lower interest rate than their more traditional counterparts among Treasury bonds. And let’s be honest, Treasury bonds pay paltry interest to begin with. 
  2. Little Value During Low Inflation. Most of the time, inflation doesn’t surge upward. When it plods along at its standard 2% to 3%, TIPS just don’t provide much value or returns. 
  3. Deflation Cuts Interest Payments. If deflation drives prices down, you really start regretting your TIPS investment. While Uncle Sam will still give you back your initial principal when the bond matures, you’ll still collect lower interest payments in the meantime. 
  4. Regular Income Taxes on Interest. The IRS taxes your semiannual interest payments like dividends rather than capital gains, because you earn them as income within the same year. That means TIPS interest gets taxed at the higher income tax rate.

​​

Should You Invest in TIPS?

Treasury inflation-protected securities offer a valuable hedging tool for your personal investment portfolio. They protect you against inflation without the heightened risk of commodities or precious metals.

That makes them low-risk, low-return investments — a safe-haven investment for playing defense, particularly if you worry a rise in inflation is coming. As low-risk investments, they make for a good short-term investment to simply avoid losing money to inflation.

I sometimes keep savings in a TIPS ETF to avoid losses from inflation while parking money. As a real estate investor, I typically set aside money for upcoming property purchases, but I don’t always know when I’ll need that money. A deal might come along next month, or I may need to wait a year for the right deal.

As safe as TIPS are, however, the majority of your money should work harder for you, in asset classes that earn a higher rate of return. Speak with a financial advisor about the ideal asset allocation for your age and long-term goals.

Treasury Inflation-Protected Securities FAQs

Don’t feel embarrassed if you still have questions — TIPS get a bit mind-bending. Below are a few common ones that many investors have when first exploring TIPS.

How Can I Buy TIPS?

You can buy new TIPS directly from the TreasuryDirect.gov website, or you can buy “used” TIPS on the secondary bond market. Alternatively, you can buy bond funds that own TIPS through your brokerage account, such as ETFs or mutual funds. 

Can TIPS Lose Money?

When TIPS bonds mature, they pay you back the greater of either your original investment or, more likely, a higher face value that’s been adjusted upward based on inflation. Plus you earn interest for the life of your TIPS bond. 

In other words, short of the U.S. government disappearing or going bankrupt, you can’t lose money if you hold them for the life of the bond. But they could lose value on the secondary market due to interest rate risk — more on that momentarily.  

How Are TIPS Taxed?

You pay federal income taxes on the interest payments you receive, at your regular income tax rate. When TIPS mature and pay you back your inflation-adjusted principal, you owe capital gains tax on your “profit” above your original investment. 

However you don’t have to pay state or local income taxes on your TIPS returns.  

What Happens to TIPS When Interest Rates Rise?

Like all bonds, existing TIPS go down in value on the secondary market when interest rates rise. Older bonds paying lower interest rates lose their luster when the Treasury starts issuing shiny new ones that pay better.

But sometimes the Federal Reserve raises interest rates to battle high inflation. In that case, TIPS holders benefit from a greater inflation adjustment to the face value of their bonds.

Final Word

If you suspect higher inflation lurks in the near future, TIPS can make a great addition to your portfolio.

With virtually no risk of losses and fast liquidity, they offer an easy hedge against inflation risk. The federal government guarantees you won’t lose money on them.

But that doesn’t mean they pay well. You could easily find yourself earning one-tenth the long-term average return of stocks. As you plan your investment strategy, consider TIPS as a conservative backstop for inflation protection rather than the main force of your money working to earn you a return.

How To Tell if You Should Buy a House Now

Poprzedni wpis

5 Best Biotech Stocks to Buy in 2022

Następny wpis

Mogą Ci się spodobać

Komentarzy

More in Artykuły