Categories: Investments
      Date: Sep 19, 2009
     Title: Worried About Inflation? Consider TIPS

Economists are a worrisome sort. Currently, many are concerned about the dangers of deflation. Others are scared that massive government spending and increases in the money supply will bring on higher inflation that we haven't seen for over 25 years. Most economists hedge their bets and worry about both.

The fact is inflation is always a risk, and certainly something to be concerned about when you are saving and investing to prepare for future expenditures (think college and retirement). One investment that can protect you from unexpected inflation while helping to diversify your portfolio is Treasury Inflation-Protected Securities, or TIPS.

In this article we'll look at what TIPS are and how they differ from other bonds. Part 2 will follow and discuss a number of key attributes of TIPS for your consideration before making them a part of your investment portfolio. In Part 3 we'll look at your options in how to invest in TIPS.

TIPS are a special type of U.S. Treasury bond that automatically adjust for changes in the Consumer Price Index (CPI), protecting the investor from the negative impact of unexpected future inflation. Although an investor should not anticipate exciting returns, TIPS are arguably the safest and purest inflation hedge available to Americans. Although inflation protected securities have been issued in more than twenty other countries, starting with Finland in 1945, the U.S. did not make TIPS available until 1997. TIPS are currently issued in 5, 10, and 20 year maturities. Available initially, 30 year maturities were discontinued in 2002.

To understand how TIPS work, it is best to compare them to conventional Treasury notes and bonds. With conventional (nominal, or non-inflation protected) Treasuries, the investor earns the stated coupon (or interest) rate on the face value of $1000. In a simplified example, a ten-year note with a 6% coupon would pay $60 ($30 semi annually) on the $1000 investment. At maturity in ten years, the investor would receive the $1000 face value back from the U.S. government. The interest rate on these conventional notes can be thought of as a combination of an inflation expectation plus a real (inflation adjusted) interest rate. In this example, the 6% interest rate may represent a market expectation of 3% inflation, along with a 3% real interest rate. Thus, the conventional note provides a return that compensates investors for expected inflation and the real interest rate (i.e. the market cost of the capital provided). However, if inflation ends up to be higher than the market anticipates, investors will earn a lower or even negative real (i.e. inflation adjusted) return.

A ten-year TIPS issued at the same time may have a coupon rate of only 2.75%, compared to the 6% coupon on the conventional Treasury note in the example above. The 2.75% rate is even slightly lower than the 3% real interest rate expected to be earned on the conventional note, reflecting the fact that the TIPS investor is not subjected to the risk of unexpected inflation. (Remember, higher returns are compensation for higher risk, and lower levels of risk are accompanied by lower returns.) TIPS investors accept this lower stated interest rate because their return will be augmented by an inflation adjustment tied to the change in the CPI.

Although you may think that the TIPS' coupon rate would be adjusted for inflation, the adjustment is actually made to the principal, or face value, of the note. If after the first year the CPI rises 4.5%, the $1000 face value of the note will have been adjusted to $1045. The coupon rate stays constant, but will be applied to this higher principal, resulting in a higher semi-annual payment. The initial coupon payment of $13.75 (1/2 x 2.75% x $1000) will rise to $14.37 (1/2 x 2.75% x $1045). If the CPI continues to go up at a rate of 4.5%/year, the face value of the note will have increased from $1000 to over $1,550, and the investor will receive that amount back from the U.S. Treasury.

In the simplified (e.g. no tax impact, no premium or discount on the notes which are held to maturity) example above, the TIPS investor has earned a total return of approximately 7.25% per year on his investment over the ten years. This return is a combination of the 4.5% inflation adjustment and the 2.75% real return. The conventional treasury investor would not have fared so well--earning a nominal return of 6% and real return or only about 1.5%. The TIPS investor was effectively protected from the impact of the higher than expected inflation.

In real life, the TIPS investor will not always fare better than with conventional Treasuries. When inflation ends up to be less than or equal to expectations, the investor will earn a higher real return in nominal Treasuries of comparable maturity. Over the long run, you would expect slightly lower returns with TIPS than similar conventional Treasuries--after all, you are exposed to less risk. This isn't necessarily a bad thing, however, since the smart investor doesn't look to just maximize his return, but is also carefully managing his risk.

Learn more about TIPS in Parts 2 and 3.