Ask Terry Questions TIP Fund Investments As Protection from Rising Future Rising Interest Rates

TIP Fund Investments As Protection from Rising Future Rising Interest Rates

By Terry Savage on August 17, 2014 | Investments

Terry, at my age 67 yrs I have a significant portfolio to live on in retirement years. My situation is that I’m not concerned about growth but in savings preservation. Considering the current situation with low interest rates, TIPS funds have been a poor investment vehicle. What’s your opinion in the future for investing in Treasury Inflated protected security funds at Vanguard or Fidelity? Thank you

Terry Says:  Actually, I should disclose that I’ve owned a TIPS fund (at American Century) for well more than a decade, right after I first wrote about them.  It has performed well — but NOT because of the inflation protection(there hasn’t been any lately!), but because as interest rates fell, share prices have been positively impacted. It is part of my “chicken money hedge” — but it certainly hasn’t performed as  well as the stock market!

If you’re a regular reader, you know I think that all this money creation will — eventually — lead to inflation.  But I’ve been thinking that for a long time,  and the only “inflation” we have seen is in stock prices.  The TIPS fund would be a hedge against that possibility of future inflation — because bond prices won’t fall as much when rates rise, since they have an “adjustment” to value based on inflation.   But even with that “adjustment” I’m not sure I would buy a TIPS fund now, because the “adjustment” in the future might not be enough to keep up with real inflation.

Perhaps I should include an explanation for those who do not understand how TIPS work:  TIPS are bonds issued by the US Treasury that pay a coupon on the adjusted principal of the bond. The bond is adjusted on a semi-annual basis with the rate of the Consumer Price Index (a measure of inflation). So, TIPS are said to keep pace with inflation by returning the adjusted principal upon maturity and coupon payments along the way.

But you have to remember three important things with TIPS funds:

  1. Inflation is “determined” by the government — and the statistics we’ve seen re the consumer price index may not reflect YOUR inflation as you grow older.  Medical costs, etc have continued to outpace the reported CPI.
  2. TIPS funds should be bought inside a retirement plan, such as an IRA — because otherwise you must pay taxes on the “phantom income” that comes from the adjustment to the price each year based on inflation.
  3.  Prices of TIPS fund can be volatile — changing on expectations of future inflation rates.  So there is no guarantee that when you want to get out of your fund you will get all your money back, plus those “inflation adjustments.”  The price of the bonds owned by the fund will be determined by the market, based on inflation expectations.

Also, note that you can buy TIPS either inside a managed mutual fund such as the ones you mentioned, where the portfolio manager adjusts the purchase of bonds as older bonds may mature, or based on his/her expectations of price movements.  But you can also buy an ETF — exchange traded fund that holds TIPS.  So do your research before you invest.




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