With the recent focus on inflation, there are have been discussions about TIPS, or Treasury Inflation-Protected Securities. We dive into TIPS and explore where we think they best fit in an investment portfolio.
With the inflation rate, measured by the Consumer Price Index (CPI), gaining 5.4% from a year ago in June, investors have become very focused on inflation and whether it will remain elevated. As a result, different inflation focused investment options have been discussed significantly in the financial press. One frequently discussed investment is TIPS, or Treasury Inflation-Protected Securities. This month, we thought it would be helpful to provide a deeper dive into TIPS and where we think they best fit in an investment portfolio.
TIPS are Treasury bonds that provide investors protection from inflation risk. The annual interest rate paid by TIPS, or coupon payment, increases at the rate of inflation as determined by the CPI. Thus, you are assured of earning a “real rate” of return – a return that is not eroded by inflation. As inflation increases, the par value of TIPS increases, while the interest rate remains fixed. Therefore, the purchasing power of the principal invested in TIPS will increase with inflation as well. When buying a standard bond, there is typically a fixed coupon payment that is paid over the life of the bond. The interest rate that the bond will pay is based on several factors including time horizon, credit quality of the issuer and the future expected rate of inflation at the time of issuance. However, after issuance, if inflation increases above expectations, coupon payments from the bond are worth less as they do not have the same purchasing power. When pricing bonds, the current future expectations for inflation are factored into its value, however, the rate of inflation is constantly changing and as a result the bond could under or outperform that expectation depending on the path inflation takes. In addition, given the assurance that an investment in TIPS will maintain its purchasing power, it typically pays a slightly lower interest rate than a Treasury bond with a comparable maturity.
Holding TIPS protects an investor from unexpected inflation. RIA does not recommend trying to time inflation or predict whether current inflation projections are right. When incorporated in a portfolio, RIA would recommend TIPS as a permanent piece of a portfolio rather than a short term tactical holding. RIA does not recommend moving in and out of a TIPS allocation based on predictions of the pace of future inflation.
Given TIPS are issued by the US government and are considered very high credit quality holdings, they align with RIA’s recommended emphasis to high quality fixed income. RIA views the role of fixed income as providing stability for a portfolio by acting as a counter balance to the more volatile equity side of the portfolio.
As RIA believes markets to be highly efficient, new information is reflected in security prices immediately. This includes the market’s future expectations for inflation. Over enough time, we believe it is equally likely that the market could under or over project the rate of inflation. Therefore, it’s likely the market will do a reasonable job of pricing it in. As a result, having a broadly diversified fixed income allocation will likely serve an investor well. Also, we believe investors with a very long time frame are better served using stocks as an inflation hedge to maintain purchasing power. RIA does not recommend TIPS for investors with very long time horizons and those that have balanced or growth-oriented portfolios. RIA views the equity allocation in a portfolio as a significant hedge against inflation.
RIA would consider TIPS as an option for an investor that is particularly inflation sensitive and has a more finite time horizon. Those investors that are more conservative in their investments and have a large fixed income allocation may also be candidates for holding TIPS. Without significant equity holdings, conservative investors do not have the same inflation protection as an investor with a more balanced stock to bond allocation. In addition, given how TIPS are taxed, they are best held in tax-deferred or nontaxable accounts.
While recent inflation has accelerated at levels not seen in over a decade, the future pace of inflation is an unknown. As a result, it is our view that an allocation to TIPS may be reasonable for specific investors with shorter time horizons and a very conservative allocation.