The latest edition of the consumer price index showed that inflation was running at a pace of 7.5% in January, representing a 40-year high. Moody’s Analytics estimates that the average household is spending an additional $250 a month, or $3,000 per year.
That’s not good news for retirement savers. And some might consider the stock market to be a bit frothy these days. So, it might make sense to invest a portion of your retirement nest egg conservatively and in a way that also offers some protection against inflation. Here’s an idea:
Treasury Inflation Protected Securities (TIPS)
Consider investing some money in U.S. Treasury Inflation Protected Securities (TIPS). These are a special variety of Treasury Bonds that are adjusted for inflation. Specifically, in times of inflation, TIPS principal balances are adjusted upwards twice a year, based on changes in the Consumer Price Index. So, inflation doesn’t hurt you as much. In contrast, significant inflation deals out serious punishment to those who follow the knee-jerk conservative investment strategy of buying regular U.S. Treasury Notes or Bonds.
How TIPS work in a nutshell
TIPS are sold with terms to maturity of 5, 10, and 30 years. They pay cash interest twice a year at a fixed rate that’s set at issuance. During times of inflation, TIPS principal balances are adjusted upwards twice a year.
You receive the following if you hold a TIPS Bond to maturity:
1) Cash interest payments twice a year at the stated fixed rate. Each semiannual payment equals half the stated rate times the inflation-adjusted principal balance at the time of the payment. So, your interest payments go up with inflation because they are based on the increasing inflation-adjusted principal balance.
2) The inflation-adjusted principal balance at maturity, which has been increased by the inflation that was measured during your holding period.
Super-simple example: On 4/15/22, you invest $100,000 in an original issue five-year TIPS Bond with a face value of $100,000 that pays a 3% fixed annual interest rate. If inflation for the next six months is 2%, the inflation-adjusted bond principal balance is increased to $102,000 ($100,000 x 1.02), and you will receive a $1,530 interest payment for that six-month period ($102,000 x 3% x .5 = $1,530).
If the inflation rate for the following six months is 3%, the inflation-adjusted principal balance is increased to $105,060 ($102,000 x 1.03), and you will receive a $1,576 interest payment for that six-month period ($105,060 x 3% x .5 = $1,576).
If inflation runs at exactly 2% for every six-month period for the next four years, your interest payments will increase based on the inflation-adjusted principal balance for each six-month period. You will receive $123,095 at maturity ($105,060 x 1.17166) on 4/15/27.
The real world
In today’s real world, you’ll have to pay a premium for the inflation-protection privilege. For instance, the 5-year TIPS Bonds maturing on 10/15/26 pay interest at a microscopic fixed annual rate of .125%. As this was written, these Bonds were trading for a premium of about 1.07 in the secondary market to yield negative 1.322%, based on the 1.125% fixed interest rate. The Bond’s current inflation-adjusted principal balance factor was 1.013, so you would pay about $107,000 to buy one of these Bonds with an inflation-adjusted principal balance of $101,300.
If there’s significant inflation, the twice-yearly interest payments will increase as the inflation-adjusted principal goes up. But the interest payments still won’t amount to much because the fixed annual rate is so low (.125%)
If there is significant inflation, the real money is earned from the fact that you’ll collect the inflation-adjusted principal balance if you hold the bond to maturity.
Real-world example: On 1/15/21 you pay $107,000 to buy a 5-year TIPS Bond with a face value of $100,000, an inflation-adjusted principal balance of $101,300, and a fixed annual interest rate of 1.25%. The Bond matures on 10/15/26. If you hold the TIPS Bond to maturity and inflation runs at about 1.32% during your ownership period, you’ll recover your investment and break even on the deal. That would not be good, because you could currently earn an annual yield of about 1.5% on a regular 5-year Treasury bond, and you would obviously more than break even on that deal. Ignoring inflation! In rough numbers, you would need annual inflation to exceed about 2.82% (1.32% + 1.5%) for your TIPS investment to come out ahead of the regular Treasury Bond.
But if inflation averages about 7% during your ownership period of four years and nine months for the TIPS Bond maturing on 10/15/26, you would come out well ahead. At the end of the day, you would collect about $140,500 from your $107,000 investment. If you invested the same $107,000 in a regular 5-year Treasury Bond that pays 1.5% annual interest and matures on 10/15/26, you would only accumulate about $115,000 during your ownership period of four years and nine months.
Bottom line: TIPS have a big advantage over regular Treasuries if there’s significant inflation.
What if there’s deflation?
Good question, while deflation anytime in the near-ish future looks pretty unlikely right now, you never know. If we’ve learned one thing in the last couple years, it’s that anything can happen. Right?
During periods of deflation, TIPS principal balances are adjusted downward twice a year. The twice-yearly interest payments are also adjusted downward — because they are based on a declining adjusted principal balance. The stated fixed interest rate itself doesn’t change.
However even in the worst-case scenario of significant deflation during your ownership period, the results from owing a TIPS Bond won’t be catastrophically bad, as long as you hold the Bond to maturity. That’s because you’re guaranteed to receive at least the face value of the Bond at maturity, even if the adjusted principal balance has fallen below that number. If the inflation-adjusted principal balance exceeds the face value, you’ll receive the larger inflation-adjusted number.
So, in our previous example, you would collect at least $100,000 when your TIPS Bond matures on 10/15/26 — even if there’s significant net deflation during your ownership period of four years and nine months. However, this is certainly not a great result, because you paid $107,000 for the Bond and only earned minimal interest during your ownership period.
How to buy TIPS
The minimum face value for a TIPS Bond is $1,000. Larger denominations are available in $1,000 increments. TIPS can be purchased upon original issue directly from the government through the online Treasury Direct program. See here. However, the Treasury Direct option is only available for TIPS purchased for taxable accounts. You cannot use a tax-favored retirement account, such as an IRA, to buy TIPS upon original issue.
If you buy a newly issued TIPS Bond via Treasury Direct, you’ll receive at least the face value of the Bond if you hold it to maturity, even if there’s significant deflation. TIPS are marketable securities, so you can buy previously issued TIPS Bonds in the secondary market through your friendly brokerage firm. The commission charges should be reasonable.
If you buy older TIPS in the secondary market with an accrued inflation adjustment to the principal balance, that adjustment can vaporize with deflation. The way to avoid this risk is to buy TIPS when they are issued or shortly thereafter. That way the accrued inflation adjustment will be little or nothing, and you’ll have less to lose in the event of deflation. Of course, if you pay a premium for the Bond, you can potentially lose that too.
Key point: As with other Treasuries, secondary market prices for TIPS Bonds fluctuate due to changes in prevailing interest rates, supply and demand, and other factors. If you don’t intend to hold your TIPS to maturity, you must understand that market prices can and do change on a daily basis, and there’s no certainty about how much you’ll be able to sell your TIPS for in the secondary market.
Tax issues for TIPS held in taxable accounts
When you hold TIPS in a taxable brokerage firm account, your taxable income will include: (1) the cash interest payments and (2) any positive inflation adjustments to the principal balance. Paying current taxes on the inflation adjustments is not good, because you won’t actually collect them until the TIPS matures or you sell it in the secondary market. In other words, you’re paying taxes on “phantom income.” You can avoid that issue by holding TIPS acquired in the secondary market in a tax-advantaged retirement account–such as a traditional or Roth IRA, 401(k), or SEP.
The good news is that you won’t owe state income tax on TIPS cash interest payments or inflation adjustments for TIPS held in a taxable account.
As explained earlier, if deflation occurs, the adjusted principal balance of your TIPS Bond is adjusted downward, which will lower your cash interest payments.
For tax purposes, a negative principal balance adjustment first reduces your taxable interest income from cash interest payments received in the year of the adjustment. If the negative adjustment exceeds your cash interest payments, the excess you can generally claim a deduction to the extent you previously had taxable interest income from cash interest payments. Any remaining negative adjustment is carried forward to reduce your taxable income from cash interest payments in n future years. If you still have a remaining negative adjustment amount after all that, you’ll have a capital loss equal to that amount when you sell the bond or it matures.
Key point: None of this tax stuff matters if you hold your TIPS investment in a tax-favored retirement account. The money you make or lose will simply affect the retirement account balance, and the amount you will eventually be taxed on when you take withdrawals.
A simpler alternative: TIPS ETFs
A simpler alternative is buying shares in an exchange traded fund (ETF) that invests in a basket of TIPS Bonds that will simulate the results from directly investing in TIPS.
Broad spectrum TIPS funds include the iShares TIPS Bond ETF (TIP on the NYSE), the Schwab U.S. TIPS ETF (SCHP on the NYSE), and the PIMCO Broad US TIPS Index ETF (TIPZ on the NYSE).
One medium-term maturity date TIPS ETF is the SPDR Bloomberg Barclays 1-10 Year TIPS ETF (TIPX on the NYSE).
Shorter-term maturity date TIPS ETFs include Vanguard Short- Term Inflation-Protected Securities ETF (VTIP on the NASDAQ) and the iShares 0-5 Year TIPS Bond ETF (STIP on the NYSE).
If you hold these ETFs in a taxable account, you will receive some taxable distributions during the year, some of which may be capital gains.
As an example of one TIPS ETF’s recent performance, the Schwab SCHP fund had a total return of 5.8% in 2021, 10.94% in 2020, 8.36% in 2019, and – 1.31% in 2018.
The bottom line
As you can see, investing in TIPS can be profitable in the right circumstances and unprofitable in the wrong circumstances. It’s up to you to take your best guess and act accordingly. I’ll be doing the same. Good luck to us all.