With the oncoming threat of an economic recession, rapidly rising interest rates and inflation, many investors will look for ways to protect their funds from the effects of inflation. Treasury Inflation-Protected Securities, otherwise known as TIPS, are US government backed bonds that can be the perfect safety net in rough times.
This is one of the best tips that I can offer for a hedge against inflation. While TIPS bonds can be a perfect hedge with low downside risk, they can also be quite confusing for new investors. I'm going to help you out there and teach you everything I know about US Treasury Inflation-Protected Securities.
What are TIPS?
US Government bonds are often the backbone of most low-risk investment portfolios. They offer investors a guaranteed rate of return on their funds. As a result, they're considered to have very low risk. This works perfectly in normal economic times. However, recessions and runaway inflation can be a major exception. As a result, the Government created Treasury Inflation-Protected Securities in 1997 to offer protection against this scenario.
When inflation outpaces the returns seen from a normal treasury bond, you're technically losing money over time. Even though you make a profit, the value decreases more than your profit to give you a negative nominal return. TIPS solves this problem by adjusting your investment principal every six months based on the rate of inflation. This is a cumulative adjustment too, so the principal balance can continue to increase every six months as long as inflation is high.
TIPS are often overlooked by beginner investors because of their stated interest returns. Compared with a normal bond, TIPS will almost always appear to be the least attractive option if you only pay attention to the interest rates. However, the principal adjustments because of inflation are where TIPS win out.
Inflation Portfolio Risks
During times of high inflation, economic turmoil usually comes along with it. This often causes worldwide markets to fall. Investments often lose money in the short term. While your investments are losing value, inflation is simultaneously eating away at the purchasing power of your money. This causes a double whammy to an investment portfolio.
This scenario is usually worse for bonds than it is for stocks in a normal market. Stock prices that fall are like to go back up long-term. They may even erase their losses. With bonds, you are stuck at a set interest rate, which is usually lower than average market returns over time. As a result, it's easier for inflation to outpace returns on bonds compared to stocks. This is especially the case if you're talking about five or 10-year lengths of time.
Cash holdings are also at-risk during inflation. During a recession, investors will often sell stocks to avoid falling values. They'll then sit on this cash thinking that they have protected their portfolio funds against the recession. However, this approach can cause more harm than good since that cash will lose purchasing power with high inflation.
When & Where to Buy TIPS
When inflation starts to outpace bond and even market returns, your money may be better off sitting in TIPS bonds. However, you need to be careful about when you enter the TIPS market to ensure it is worthwhile. Bonds vs TIPS have a breakeven point where they're both estimated to have equal returns in the future after adjusted for inflation. When inflation outpaces the breakeven point of normal bonds, it's usually the right time to switch to TIPS. The breakeven amount is the difference in yields. BONDS rate - TIPS rate = breakeven point.
Keep in mind that TIPS can be sold any time after an initial holding period (usually 45 days). However, they are sold for specific terms. When you let a TIPS bond reach maturity, you'll get back the highest of your original investment or the new adjusted principal. If deflation sets in while you hold TIPS, it could reduce the principal and cause a loss. Holding TIPS to maturity can protect against this situation though.
TIPS are sold at auction by the US government at the beginning of each quarter each year, in January, April, July and October. You can also buy them any time on the secondary market. Fidelity offers this service.
In many ways, the downside risks of TIPs are very minimal. Since they're treasuries backed by the USA Government, you're guaranteed that you won't lose your investment. You can also trust the rate of returns stated. On top of that, holding TIPs to maturity can protect against potential downside risks because of deflation.
The main risk that you want to be careful about is the risk of an underperforming portfolio holding TIPS. This is a hedge against inflation and not intended to give you great returns. This is why interest rates are often negative with TIPS - the idea is to come out on the other side of inflation without losing a ton of purchasing power, not to make a big profit.
Ideally, you really want to hold TIPS only while inflation is outpacing market and/or bond returns. When the breakeven point is crossed again on the downside in the future as deflation sets in, you need to shift your portfolio back to normal for the best returns.
Other Noteworthy Info
Owning TIPS can have potential tax ramifications. If inflation is causing the principal balance on your TIPS to rise every six months, this increase is counted as income and is taxable. Unlike other capital gains that aren't taxed until you sell an asset, this aspect of TIPS gets taxed twice a year. There are ways to hold TIPS in a tax deferred account to avoid this downside though.
The negative interest rates often offered with TIPS are the main thing that throws off new investors. Why do you want to hold something that will earn negative interest, which means you pay to hold that security? Real vs nominal yield is the answer.
Interest rates on bonds do not factor inflation. Since TIPS principals are adjusted for inflation, you can actually get back more money than you put into it. This is still the case even with a negative interest rate as long as inflation is higher. The idea is to keep pace with inflation and not to generate a profit.
There's a lot of economic turmoil and a likely recession coming on the backend of COVID. Treasury Inflation Protected Securities are an increasingly popular option as a hedge against inflation now. This trend will likely continue for the next couple of years and possibly more.