Market Overview
TIPS on protecting your nest egg from inflation
If you have a bond that pays 2% interest per year, but annual inflation is 3%, have you actually made any money?
No. In real terms, your bond lost 1% in value.
Here are a couple ideas on how you can avoid that mistake.
Really interesting
First, let’s make sure we’re clear on a few concepts – and some basic vocabulary.
To proceed from the example above, the 2% annual yield on that bond is called the “nominal interest rate”. When you subtract the inflation rate, you’re left with what financial analysts call the “real interest rate”. The investment sketched out above, then, would have a real interest rate of -1%. In other words, if you invested $100 at the end of 2022. While the value of the asset went up to $102 by the end of 2023, the value of that 2022 money went down to $97 in the same timeframe. So you end up, in real terms, with only $99 on a $100 investment.
Let’s make this case a little more appealing. Instead of 2%, let’s say the bond yields a 6% nominal rate. Inflation, though, remains a persistent 3%. So now your real interest rate is 3%. While you’re still coming out ahead, it’s important to consider the real interest rate in the context of your investment risk. For the same level of risk, is there another vehicle you could be in that would give you a higher real yield? Or might there be a lower-risk way of accruing that same 3% real interest rate?
Cue TIPS
If only there were bonds that automatically adjusted to maintain the real interest rate. Actually, there are and have been since the Massachusetts Bay Company dreamed them up in 1780, when the new U.S. dollar was contending with a 12.3% inflation rate.
The U.S. Treasury has issued inflation-indexed bonds in their current form since 1997. While that wasn’t helpful to investors during the high inflationary environment of the 1970s and early 1980s, they were still useful tools from their inception, when inflation ran at a 7.5% annual clip.
Since the current spate of above-target inflation took root, the government has auctioned between $15 billion and $20 billion worth of these Treasury Inflation Protected Securities, or TIPS (singular or plural), every month. You can get in on them starting at $100. TIPS are issued for five-, 10-, or 30-year terms.
Unlike other Treasury securities, the principal of a TIPS is not fixed. This is actually a brilliant bit of financial engineering. As the bondholder, you get the same interest payment every six months. If inflation goes up, though, the price at which Treasury will buy your TIPS back from you goes up as well.
An example is helpful. Let’s say you just bought a TIPS for $100. The nominal rate it pays is 2%. You would get $2 per year in interest; these are semiannual, so that’s $1 every six months. You will keep getting that dollar every six months for the whole term of the TIPS. But the value of the bond itself will keep pace with inflation, as determined by the Labor Department’s Consumer Price Index. If the annual inflation rate is 3% then next year your bond’s face value will rise from $100 to $103.
If inflation reverses, don’t worry. Your TIPS will still be worth at least $100. Also, you have the discretion to hold the instrument until maturity or to sell it before then. Treasury has a buyback program, and there is a secondary market for them. Here’s the gateway to all things TIPS.
You may have spotted a fly in the ointment, though. When that bond increases in value from $100 to $103, that increase in value is a capital gain. . That’s why TIPS are more attractive when held in a qualified retirement plan or some other tax-shielded account, where taxation on capital gains isn’t an issue
TIPS are one of two – and by far the better known – inflation-adjusted Treasury instruments. There are also Series I bonds. These $25 savings bonds are more like gifts you give when a niece or nephew is born – you know, the generic Series EE savings bonds – but with a similar mechanism to account for rising prices.
The payout
It’s good to know about these inflation-resistant fixed-income options, but you probably don’t have all your money in bonds. In fact, for most investors, bonds represent a more modest portion of their portfolios. Any discussion along these lines needs to at least mention industrial sectors in which equities tend to do well when inflation is running hot.
According to Investor’s Business Daily, “Inflation is bullish for oil and emerging markets stocks. And stocks in general do fine during periods of rising inflation, too.”
Matt Krantz’s article, citing Wells Fargo research, goes on to note, “Small stocks top large ones [during inflationary periods]. And S&P 500 growth stocks outperform value.”
A trusted financial advisor can help you find the right funds or individual stocks to ride the inflationary wave, as well as the appropriate portion to hold in fixed-income instruments.
