by Alexander Green, Chief Investment Strategist
Monday, May 10, 2010: Issue #1256
Two weeks ago, I wrote a column recommending Treasury Inflation-Protected Securities (TIPS) as protection against potential inflation down the road.
It prompted a flood of questions and challenges. I want to address those, but let me start by briefly re-stating my case:
- Unprecedented government spending – including $108 trillion in unfunded liabilities for social security, Medicare and new universal healthcare benefits – is putting the nation at risk.
- With interest rates near zero, the Federal Reserve cannot take one traditional step – lowering short-term rates – to revitalize a weakened economy.
- In a severe economic downturn or double-dip recession, politicians – with the reluctant assistance of the Fed – could opt to spend even more massively to try to jump-start the economy.
- The result could be stagflation: slow growth with higher inflation. (And although we haven’t seen it here in almost 30 years, perhaps even hyper-inflation.)
I don’t know what the odds of this happening are – and neither does anyone else. But I think investors would be foolish not to at least consider the possibility…
Inflation or Deflation? Hedge Your Bets This Way…
Respondents who disagreed generally fell into one of two camps…
- They either believed that deflation is more likely than inflation.
- They thought inflation was likely, but since Congress will almost certainly be the culprit, they don’t want to reward the mischief-makers by buying any kind of government securities.
Let me handle the former objection first: Is deflation more likely than inflation? Perhaps. No one can say. You should probably own a good slug of Triple-A insured municipal bonds just in case. (Because future tax rates are almost certainly going higher.)
By all means, make some plans for a deflationary scenario. But plan for the possibility of inflation, too. This is what diversification is all about. Hedge your bets.
But why use TIPS as your hedge, rather than a traditional inflation hedge like precious metals? In my view, you should use both. But remember, gold and silver are less than perfect hedges.
They have both performed exceptionally well over the last 10 years, for example. Gold has more than quadrupled. Silver has done even better. But the 20 years before that were an unmitigated disaster.
But no matter whether inflation is low or high, TIPS will protect you. How?
The Benefits of Buying Treasury Inflation-Protected Securities
- Regular Interest Payments: TIPS pay interest every six months, just like a regular Treasury bond. But unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation.
- Tax Benefits: The interest you receive is exempt from state and local income taxes (but not federal). TIPS are also less volatile than traditional bonds and are also excellent diversifiers.
There are three good ways to buy inflation-protected Treasuries:
- Directly: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm
- Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
- Through its ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).
I recommend TIPS for two primary reasons…
- I’m not a moralist trying to claim the high ground. I’m just trying to protect myself, my family and my heirs from potentially destructive hyper-inflation. I don’t want to remain true to my free-market principles only to see the net worth I’ve accumulated over a lifetime torpedoed.
- There is no private-sector alternative here. For good reason, private and public companies don’t want to leave themselves vulnerable to sky-high interest and principal payments down the road if inflation takes off. So they don’t issue inflation-protected securities. That makes TIPS the only game in town.
I know that some libertarians and laissez-faire capitalists will refuse to buy Treasury securities, period. But as I’ve pointed out, other inflation hedges sometimes don’t work. So there is no small risk taking another approach.
In sum, there is only one investment that guarantees a return that exceeds inflation in the years ahead: TIPS.
And in my view, that makes them an indispensable part of your portfolio.