Inflation Isn't Dead, Just Sleeping – And TIPS Can Protect You When It Awakens

[Editor's Note: In the current economic malaise, inflation has become a forgotten foe. But it could come back. This latest installment of Money Morning's "Defensive Investing" series details a low-risk strategy for dealing with that age-old enemy of long-term investors.]

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Investors are always on the lookout for hot tips. The best tips highlight investments that pack a big potential profit punch, but that haven't yet started their move.

That's just what we have for you here.

We're not talking about the "inside scoop" on some obscure stock. What we're referring to are government-backed "TIPS" – or, as they're more formally known, Treasury Inflation-Protected Securities.
Defensive Investing

Admittedly, inflation hasn't been a major concern of late. The U.S. Consumer Price Index (CPI) was actually down by 0.2% in May, extending a 0.1% drop in April, while May's core inflation – which is the CPI measured without the volatile food and energy components – was just 0.1% higher. That's why many market analysts and media pundits are now saying deflation is much more of a worry for U.S. markets than inflation.

However, many of Money Morning's top experts – including Chief Investment Strategist Keith Fitz-Gerald and Contributing Editor Martin Hutchinson – disagree with that assessment. Recognizing the inevitable inflationary impact of increasing deficit spending, growing federal debt, rising state and local taxes and a weakening U.S. dollar, they see renewed upward price pressure not too far down the road.

That makes this the perfect time to learn about TIPS and how they can protect you when inflation again rears its ugly head.

Offered by the U.S. Treasury Department at regularly scheduled auctions, TIPS are very similar to other U.S. government debt securities – U.S. T-bills and Treasury bonds, for instance – but with one distinguishing feature: The face value of TIPS changes every six months, based on the current rate of inflation (or deflation), as measured by the CPI.

In other words, when the CPI rises, the face value of all TIPS rise by a similar percentage. And when that index falls – indicating deflation – the face value of the TIPS will decline at a similar rate. In either case, the yield on a given TIPS instrument will remain the same – though the actual dollar payout will increase or decrease because of the adjustment in the underlying face value.

However, even if there's deflation, you won't lose money if you hold a TIPS security to maturity. That's because the government will pay you either the original face value (if deflation has occurred) or the higher adjusted face value (if inflation has risen) – whichever is greater at the time the TIPS matures.

As an example of how these securities work, assume you purchase a five-year TIPS with a face value of $1,000 and a yield of 5.0%. Without inflation or deflation, your first interest payment, at the end of six months, would be $25 ($1,000 x .05/2 = $25). [Editor's Note: You divide by two because the semi-annual payment equates to one-half the annual interest rate.]

However, if inflation had risen during that six months by 10% (let's hope not), the face value of your TIPS would be adjusted to $1,100 and your interest payment would rise to $27.50 ($1,100 x .05/2 = $27.50).

Similarly, if the CPI had fallen by 10% during that same six-month period (again, let's hope not, just for the sake of at least modest economic stability), the face value of the TIPS bond would be lowered to $900 and the interest payment would drop to just $22.50 ($900 x .05/2 = $22.50).

If the CPI remained unchanged for the rest of the five-year period (fat chance), you'd get back either the original $1,000 at maturity, in the deflationary scenario, or the adjusted face value of $1,100 in the scenario where inflation rose by 10%. Barring default by the federal government – unlikely, but not impossible – you'll never get back less than your original $1,000.

Sounds like a pretty good deal – and it is – though this is obviously an overly simplified example. For a more complete and accurate table of how inflation will affect a given TIPS security and how to calculate the changes in principal you can expect from movements in the CPI, just go to the TreasuryDirect Web site and access the section titled "TIPS: Rates and Terms" and the table titled "TIPS Inflation Index Ratios."

Individual investors can purchase TIPS through banks, brokers or dealers, or directly from the U.S. Treasury through the TreasuryDirect and Legacy Treasury Direct programs using the Internet, an automated phone system or via the mail. As of April 2009, they can also be purchased by other entities, including trusts, estates, corporations and partnerships.

TIPS are issued with maturities of five, 10 and 30 years (though the 30-year TIPS aren't available via the Legacy program). And as is true of other government-debt securities, the yields are determined by auction, with the lowest bidder getting as much of the current offering as desired. The remainder of each offering is then allotted to the next lowest bidders, in order.

As an individual, you can purchase TIPS in one of two ways — through either a "non-competitive bid" or a "competitive bid."

With a non-competitive bid, you agree to accept the yield set at auction and are assured of receiving the full amount of TIPS you want. With a competitive bid, you specify the yield you want, but there's no guarantee; your bid may be:

1) Accepted in the full amount you want, if your bid is less than the yield determined at auction;
2) Accepted in less than the full amount if your bid is equal to the auction yield; or,
3) Rejected entirely if the yield you request is higher than the yield set at auction.

Individuals using non-competitive bids can buy up to $5 million in TIPS from a single auction, or up to 35% of the offering amount using competitive bids. The minimum purchase is $100, with additional sums sold in $100 increments. All TIPS are issued in electronic form rather than as paper securities, and they can either be held until maturity or sold in the secondary market prior to that time.

If you wish to buy TIPS directly from the government – rather than through a broker or dealer – you will need a Legacy Treasury Direct account. For that you'll need to fill out a paper application, providing such personal information as the bank account you want the purchase funds withdrawn from (and into which interest payments will be deposited). Use the Treasury's New Account Request form if you don't want to make an immediate purchase, or the Treasury Marketable Securities Tender form if you want to open an account and place a bid at the same time.

You can also enjoy the inflation-fighting benefits of TIPS via investment in mutual funds or exchange-traded funds (ETFs) – perhaps the most popular choice over the past few years. Two of the best-known TIPS funds – the first an exchange-traded fund (ETF), the second a regular mutual fund — are:

  • iShares Barclays TIPS Bond Fund (NYSE: TIP), recent price: $106.99 – This is the largest ETF investing exclusively in TIPS, with a market capitalization approaching $19 billion. The fund's expense ratio is 0.20%.
  • Vanguard Inflation-Protected Securities Mutual Fund (VIPSX), recent price: $12.98 – This fund has $30.7 billion in assets, 98.4% of which are invested in inflation-indexed government bonds with maturities ranging from seven to 20 years. The fund's expense ratio is 0.25%.

Together, these two funds now hold more than half of all the dollars invested in TIPS through funds. Overall, the Treasury reported more than $557 billion worth of TIPS outstanding at the end of the first quarter, attesting to their popularity.

A couple of minor caveats – and related tips on TIPS – to conclude:

  • If you buy TIPS direct from the Treasury, there are no fees. If you buy from a broker or dealer, you'll pay a sales commission, but no ongoing management fees, as you will with a mutual fund or ETF (though, as noted above, these fees are modest by typical fund standards).
  • If you want inflation protection over a set time period, you should probably hold individual TIPS in the maturities you need, since funds – by necessity – maintain diversified portfolios containing bonds of all maturities.
  • If you need a steady cash flow, some TIPS funds pay dividends quarterly rather than the semi-annual interest payments made by the TIPS themselves.
  • Income from TIPS in the form of interest payments, as well as any annual inflationary increase in the principal value, is exempt from state and local taxes – but not from federal taxes. Thus, you may want to hold your TIPS in tax-advantaged retirement or educational accounts, especially since the annual increases in face value are taxable in the year the adjustments are made, even if you don't cash them in.

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  1. Hal Cobb | July 6, 2010

    Best description of how TIPS work I've come across, thank you. Now I can better describe this instrument to my elderly mother. Hal Cobb

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