Treasury Inflation-Protected Securities (TIPS): The Indispensable Investment
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.
Good investing,
Alexander Green
Any investment contains risk. Please see our disclaimer.
8 Responses to “Treasury Inflation-Protected Securities (TIPS): The Indispensable Investment”
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Why would you trust a government that let us drift into this crisis, failed to report its extent and consistently touted its cure to provide an honest report on inflation rates? TIPS investors depend on their borrower/government to set interest income, but it’s to that borrower/government’s advantage to redefine and understate inflation, rather than account for it accurately. Seems dangerously naive.
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Totally agree!
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What about use of the Eaton Vance Senior Floating Rate Bond Fund recommended by Oxford?
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Read your TIPS advice with great interest. I am 72 years young. Your article did not recommend the percentage of a portfolio that should prudently be invested in TIPS and for how long. Your reply would be appreciated.
M. Jasnich
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RE: Your TIPS recommendation. What happens if the government defaults on its debt obligations, or devalues the dollar? Wouldn’t one lose 100% of their TIPS investment in the case of outright default and a large percentage if devalued?
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So simple, so hard to believe. Thank you.
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I read Alexander Green with great interest and while I generally accept his advice, I cannot do so for TIPS. Reason? The government is falsifying the inflation index and has been for quite some time. Critical elements are left out of their reports since it would be devastating to the powers that be if the true rate of inflation were published. Your own previous reports concerning the devaluation of the dollar over even a short period, say the last 10 years, should confirm this for you. Thus, I find investing in TIPS as a poor substitute for other types you have recommended. Diversification outside the US is probably the best advice I have read recently. Where and what is still the problem, however.
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You left out one substantial problem of TIPS. they use the CPI as a measure of inflation. The CPI is one of the biggest frauds perpetuated on the American Public by the US Govt. It doesn’t accurately track inflation. It doesn’t include food or energy which are large parts of inflation. It is MUCH lower than real inflation. And then the gov’t uses this to determine how much to raise SS etc. We also have no idea how well TIPS will actually work in a true inflationary time.
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