The United States government issues Treasury securities, including Treasury inflation-protected securities (TIPS). TIPS are inflation-indexed to protect investors from a decrease in the purchasing value of their money.
TIPS adjust the principal amount according to changes in CPI, Consumer Price Index, protecting their real value as inflation rises instead of their yield growing.
How Do TIPS Work?
TIPS' principal amount increases in line with inflation. According to the (CPI) Consumer Price Index, inflation is the rate of price growth across the whole United States economy. When there isn't a corresponding increase in actual wage growth to counteract the negative consequences of rising prices, inflation becomes a problem.
TIPS are a popular asset as they protect portfolios from inflation and benefit from it. TIPS pay interest each six months based on a rate established at the bond's auction. The rate is applied to the bond's adjusted principal amount or value. Thus the interest payments may differ.
The interest rate will increase following the increased principal amount if the principal amount is gradually raised owing to rising prices. As a result, as inflation increases, investors earn larger interest or coupon payments. In contrast, if deflation takes place, investors will get smaller interest payments.
Because the U.S. government backs TIPS, which have maturities of five, ten, and thirty years, they are regarded as low-risk investments. TIPs return the greater of the adjusted or original principal at maturity.
Some investors prefer to purchase TIPS through an exchange-traded fund (ETF) or mutual fund. Investors can, however, escape the management fees related to mutual funds by buying TIPS directly.
Benefits of Investing in Treasury-Inflation Protected Securities (TIPS)
TIPS have several significant benefits for investors who are concerned about inflation.
A simple method for creating an inflation verge in your investment portfolio is to use easy inflation insurance TIPS. According to Matt Dmytryszyn, Telemus’s director of investments, an investment advising organization in Southfield, Michigan, "TIPS is particularly crucial for more cautious or income-focused investors," such as those who are closer to retirement.
TIPS performance in high-inflation conditions may be significantly better than conventional federal bonds, whose fixed-interest costs shrink over time.
TIPS have the potential to surpass recession over the course of time, offering lot of the advantages of conventional Treasury bonds.
According to Frederick Miller, "TIPS are traded in a very liquid market and are supported by the full confidence and credit of the United States government." Hence, they are seen as free of credit risk.
You should trade your TIPS securities before their term expires, and you should be capable to do so effortlessly. It's highly improbable that the government will fail to repay you. Due to this, TIPS are low-risk investments.
Risks of Treasury-Inflation Protected Securities (TIPS) Investment
Due to their low inflation and market risk, TIPS can be secure investments. However, like traditional bonds, they are not assured investments, and their prices can change. Investors should comprehend the main advantages and risks involved.
A person who retains a TIPS bond to maturity is unaffected by price changes during the time bond is issued and the day it matures. However, if an individual sells a TIPS bond before its maturity time, this mild level of volatility could become a problem.
Another risk associated with TIPS investments is that the CPI does not accurately reflect real inflation or the increasing costs of the goods and services that investors require. In this situation, there is a danger that the bonds' inflation protection feature won't be enough to safeguard the investor's actual purchasing ability.
The improbable possibility of depression, or lowering prices, is another risk. Since there would be no inflation protection in this scenario, investors would probably sell TIPS, bringing prices down. This took place in the midst of the 2008 financial crisis when worries about a global financial collapse elevated the prospect of depression and caused a significant drop in TIPS values in that year's autumn. Although it is unlikely, depression is a possibility that should be taken into account.
Risks of TIPS ETFs and Mutual Funds
Investors who purchase bonds and keep them until maturity will experience TIPS as intended. While those who keep TIPS mutual funds or ETFs look for another risks level.
The principal amount or bonds value held by funds will undoubtedly increase along with inflation, funds offer some inflation protection. However, bond funds lack the maturity date of individual instruments. This implies that a full principal return to investors is not a given. Additionally, because TIPS are so sensitive to changes in interest rates, TIPS ETF or mutual fund value can change significantly quickly.
Investors experienced the same risk in 2010, Nov. & Dec. Bond yields increased sharply during those two months as prices dropped, pushing the returns on the 10-year United States Treasury changing from 2.66% on November 1 to 3.30% on Dec. 31. TIPS ETF such as iShares Barclays TIPS Fund, had returns of -3.8% over the same period. In May and June 2013, the fund suffered a decline of 8.1% due to a similar rise in Treasury Inflation-protected securities yields.
Since recent years' inflation has consistently ranged between 1% and 3%, these losses are significant. Therefore, it only takes a small loss to cancel out the protection offered by the funds' TIPS holdings.
Bottom Line
TIPS provide a solution for investors concerned with the threat of inflation while holding bonds, which otherwise could not yield enough to keep up with growing prices. However, the protection comes at a price, mainly poor yields in low-inflation circumstances.
