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TIPS Tackle Inflation

By Terry Savage on November 07, 2018

We shouldn’t be surprised when inflation returns to impact our lives — both in our spending decisions and in our investment decisions. After all, the conditions are ripe.

First the Federal Reserve created an unprecedented surge in liquidity to stave off financial collapse in 2008-2009. That money sat quietly until a massive corporate tax cut last year energized business to expand and hire more workers. Now, as the pool of qualified workers shrinks, it is no surprise that wages are rising. Add to that mix a series of tariffs that increase the prices of raw materials for everything from steel and lumber to consumer products, and you have all the ingredients for rising prices — inflation.

In case you don’t remember the devastating impact of inflation in the 1970s and early 1980s, here’s a simple formula to explain the devastating effects of even a small amount of inflation. It’s called the Rule of 72. Divide any inflation number into 72, and the resulting answer will be the amount of time it takes for your spending power to be cut in half.

For instance, if we have only 3 percent annual inflation, the value of your fixed retirement pension will be cut in half in less than 25 years.

One way to protect your buying power is to invest in the stock market. Over the long run — a period of at least 20 years — a diversified portfolio of large company American stocks has always beaten inflation. But what if you don’t have the “long run” and are fearful of losing some of your principal in investments like stocks that can be risky in the shorter term?

Then you might turn to U.S. government bonds. Since Treasury bonds are considered the safest IOUs in the world, they carry the lowest relative interest rate. But, as with all bonds, when the general level of interest rates rises because of inflation, the market value of Treasury bonds will fall. Who would pay $1,000 for your old 3 percent Treasury note, if they could earn 4 percent on a newly issued bond?

That’s where TIPS come in — Treasury Inflation Protected Securities. These are U.S. government bonds with a special twist that protects your returns from the devastating impact of inflation. TIPS are issued in original maturities of 5, 10 and 30 years. Each bond carries a fixed interest rate and pays semi-annual interest. But both the market value (principal) of the bond and the amount of interest you are paid (the fixed rate times the adjusted principal) will be adjusted every six months by the rate of inflation (CPI).

There are many technicalities, but basically TIPS give you protection both from a loss of market value when rates rise and from diminished spending power of your interest income along the way. One of those technicalities is the complicated way TIPS are taxed every year — partly ordinary income on the interest earned, partly capital gains on the bond price adjustments. It’s much simpler to purchase them inside an IRA.

TIPS offer protection against deflation as well. At maturity, you receive the adjusted principal value of the bond (increased because of inflation), or the original guaranteed principal — whichever is greater.

You can buy individual TIPS bonds through TreasuryDirect.gov, [use this link for a thorough explanation] although TreasuryDirect does not act as custodian for retirement accounts. Or you can buy TIPS mutual funds from low-cost providers like Vanguard and American Century funds for your IRA. Some of these funds specialize in very short-term portfolios of TIPS, while others hold longer-term securities. Or you can buy ETFs (exchange traded funds) like the iShares TIPS bond fund (NYSE: TIP) with an average seven-year maturity, or the Vanguard Short Term Inflation Protected Securities ETF (Nasdaq: VTIP) with a duration of about two-and-a-half years — and let the professionals manage the money for you.

With TIPS you get the security of U.S. government IOUs and protection against diminished buying power because of inflation, along with a “floor” value in case deflation comes along. That’s a “chicken money” trifecta. And that’s The Savage Truth.

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