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In last month’s post, we focused on what the economic future is expected to hold and discussed specific investment strategies FIM Group has employed in response to the projections. One conclusion that we’re fairly certain about is that inflation is a very real threat as we carry unprecedented deficits in the U.S. In addition to investing in companies in industries that should benefit from inflation, you may have noticed an increase in U.S. Treasury Inflation-Protected Securities (or similar holdings) in your diversified portfolio. While they have been around for more than a decade, the mechanics of TIPS are often not well-understood. This post is an attempt to take the mystery out of this important inflation-fighting investment vehicle.
One of the easiest ways to avoid losing the race against inflation is to own investments that are designed to automatically keep pace with inflation, generally referred to as “inflation-protected securities.” Introduced by the U.S. Treasury in 1997, Treasury Inflation-Protected Securities, or TIPS, have become the most widely known example.
Where TIPS differ is with their inflation-adjustment feature. Twice a year, the principal amount of the bond is changed based on the Consumer Price Index (CPI). It can go up or down. The interest rate does not change, but since the rate is applied to the adjusted principal, interest payments can vary from one period to the next. As a result, if inflation occurs, the interest payment will increase; in the event of deflation, the interest payment will decrease. The price of TIPS will fluctuate daily based on the pure bond component of the asset and the accreted inflation factor, which is based on the difference between the current CPI and the CPI at issuance. TIPS will pay a lower interest rate than comparable Treasury securities that don’t adjust for inflation, since their principal is automatically adjusted based on increases or decreases in the CPI.
Here is an example of how this works. Let’s assume $10,000 in TIPS were purchased that pay a fixed rate of interest of 2%. Over the next six months the CPI (inflation) increases at an annual rate of 3%. The principal amount would be adjusted up by 1.5% (half of the 3% annual inflation rate) to $10,150. This is the amount that the 2% fixed rate of interest is applied to resulting in a coupon payment of $101.50 for the six-month period, compared to $100 in the prior period.
Upon the TIPS maturity you receive the greater of the inflation-adjusted principal amount or the original principal. This feature protects the original investment in the event of deflation.
Since TIPS pay a lower fixed-interest rate than equivalent non-inflation-adjusted Treasury bonds, the advantage to owning TIPS is only realized if the rate of inflation over time is greater than the difference in the interest rates paid. For example, if the TIPS pay interest of 2% and an equivalent non-inflation-adjusted Treasury bond pays 4.5%, the inflation rate will need to be greater than 2.5% for a TIPS advantage.
From a tax perspective it is usually preferable to hold TIPS in tax-deferred accounts such as IRAs. That’s because if the principal of your TIPS grows in a given year, that growth will be taxed as income for the year even though you don’t receive that money until the TIPS mature.
With the strong likelihood of having to face an inflationary period in the months ahead, the use of TIPS as part of an overall FIM Group investment strategy is a safe approach to mitigating its potentially debilitating effects.
To learn about wealth management advice from the best wealth management firm, Financial & Investment Management Group -more please visit www.FIMG.net or call 800.632.5528.
