By: Phil Kernen

How do investors confront inflation and the loss of purchasing power it represents? Many investments act as effective protectors against the loss of purchasing power, but few so closely align with actual inflation as Treasury Inflation-Protected Securities (TIPS).

The benefits

The idea of a bond whose value adjusts by inflation isn’t new. The Commonwealth of Massachusetts issued them during the Revolutionary War, and the U.K. did so too in the 1980s. The U.S. Treasury first issued TIPS in 1997. They are marketable securities whose principal amount and coupon payments adjust for inflation. With a regular or nominal Treasury, the inflation-adjusted principal erodes over time, whereas the value of the TIPS bonds hold steady as inflation ebbs and flows.

Assume you have a $1,000 nominal Treasury bond. Following a year of 7% inflation, your bond’s inflation-adjusted or real value is $930 because you lost purchasing power. However, the value of the TIPS bond will adjust accordingly to retain the $1,000 inflation-adjusted value. Further, the coupon payment on the TIPS bond changes with the adjusted principal, which is why a TIPS yield is called a real yield.

The difference between TIPS yields and nominal yields is called breakeven. The breakeven reflects the market view of future inflation at different points on the maturity curve representing different time horizons. For example, if the 2-year U.S. Treasury nominal yield is 1.5%, and the 2-year U.S. Treasury TIPS Bond yield is -2.0%, the 3.5% difference is the 2-year breakeven, or the market expectation of annual inflation over the next two years.

The breakeven reflects a level of expected inflation that, if recorded, would produce the same adjusted cash flows between owning a nominal Treasury and TIPS bond. If actual inflation is higher than expected, the adjusted cash flows from owning TIPS will exceed those from a nominal Treasury, and vice versa.

While there are many ways to calculate inflation, only one method applies to the principal adjustment of TIPS: changes to the Consumer Price Index. The example below shows how the adjusted value changes as price levels change from year to year along with the interest payments.

The downsides

TIPS bonds do have downsides, including the loss of value in a deflationary environment. Deflation has the opposite effect of adjusting principal values downward. In this instance, you may have previous inflationary adjustments against which you can apply your value reduction. But this reduction can only go so far. If you hold TIPS bonds to maturity, you are guaranteed to receive the higher of the original or the adjusted value. Your $1,000 TIPS bond held to maturity will never go below that value as the result of deflation. As a result, newly issued TIPS that don’t have a long history of upward adjustments offer better protection from deflation than older TIPS with the same time to maturity.

Another downside of TIPS bonds is that their prices are subject to the movement of interest rates like nominal bonds. As rates rise, the value of TIPS bonds will go down. If price declines are more significant than the inflation adjustments, holders of TIPS bonds can lose money. TIPS bonds perform best in inflationary environments, and nominal bonds are the proper comparison for TIPS bonds. TIPS bonds will only provide better returns than nominal bonds if the reported CPI is higher than the market anticipates, as reflected through the breakeven rates.

TIPS shouldn’t be a permanent part of a portfolio. Instead, view them as an insurance policy for your bond portfolio. While they can’t protect against changing interest rates, they will help cushion the blow of lost purchasing power.

Disclosure: This is for informational purposes only and any reference to a specific type of security does not constitute a recommendation to buy or sell that security. The reader should not assume that an investment in the security identified or described, was or will, be profitable.    

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