Treasury Inflation Protected Securities: Where To Put Your Super-Safe Money Now

by Dr. Steve Sjuggerud

Treasury Inflation Protected Securities: Where To Put Your Super-Safe Money Now

By Dr. Steve Sjuggerud

Advisory Panelist, Investment U

Monday, December 30, 2002: Issue # 200

When you buy shares of Microsoft, what exactly are you entitled to? The answer is: Nothing.

When it comes to investing, there are very few guarantees. You can lose money no matter what you do. Most people don't realize it, but you often even lose money just by holding it in the bank

For example, right now as you know, banks are paying a paltry percentage rate in interest. So you think you're earning money. But in reality, you're losing ground - inflation over the last 12 months has been two-and-a-quarter percent (2.25%). The money in the bank that is worth 1.5% more in a year can't buy you 1.5% more goods at the end of the year - it will actually buy you 0.75% fewer goods.

How disconcerting is that?

There is one type of investment that will always keep up with inflation and pay you a positive return on your money. They're called Treasury Inflation Protected Securities (or TIPS), let's take a look at the facts:

Treasury Inflation Protected Securities: Make Money Better Than The Nasdaq!

I've been writing about these investments for years. And they have performed phenomenally well. I've been recommending the easy-to-buy Vanguard Inflation-Protected Securities Fund (VIPSX) to readers of my newsletter for a long time. Take a look at the annual performance of VIPSX, Vanguard's mutual fund of inflation-protected securities, since inception in mid-2000:

  • 2000: 6.02% (fund started 6/29/00)
  • 2001: 7.61%
  • 2002: 15.82%
  • 2003: 8.0%
  • 2004: 8.27%
  • 2005: 2.59%

$100,000 invested in this fund 30 months ago is now worth over $132,000 today. Meanwhile, $100,000 invested in the Nasdaq 30 months ago would be worth about $34,000 today - a $98,000 difference.

After such phenomenal results in a fund that invests in things guaranteed to make money, you might be wondering whether inflation protected securities are still a good buy. My answer is yes. It's all in how they work

The Two Types of Inflation Protected Securities

There are two types of inflation protected securities out there issued by the government - Treasury bonds (known to bond guys as "TIPS," an acronym for "Treasury Inflation Protected Securities") and U.S. Government Savings Bonds (I-series). They both basically work the same

You get paid by the government in two ways. You get:

  • A guaranteed interest rate, PLUS
  • You get paid back whatever the inflation rate is each year.

To give an example, on the Treasury Inflation Protected Securities - TIPS right now, you'll roughly get between 4.5% and 5% in interest this year: 2.25% interest on the bonds, plus inflation, which is about 2.25% this year. This is if you buy one of these inflation-protected Treasury bonds that matures in eight years. (The I-series savings bonds are paying 4.08%.)

With these investments, the guaranteed interest rate portion of your income is fixed. The inflation rate portion of your income changes, so the total amount of interest you'll get paid each year will vary. If inflation is 10% in one year, you'll get a total of 12.25% that year. However, if inflation is -5% (negative), you WON'T be penalized - you just simply won't be compensated for any inflation, as there was none. You'll just get your 2.25% interest, and that's it.

How Two Plus Two Equaled 16

Now you may be wondering how an investment that pays 4%+ in interest (2%+ interest and 2%+ in inflation) could possibly have returned 16%. It's a good question. It has to do with how you make capital gains on bonds

If you recall, when interest rates go down, bond prices go up (and vice versa). That's because if you have a bond that pays 6%, and interest rates go down to 3%, someone will be willing to pay you a lot more for your bond that pays 6%. This is what has happened in 2002: The interest rates that inflation protected securities pay went down, causing bond prices to go up. (Keep in mind that the reverse could happen as well - if the inflation protected rate rises, the bond prices would fall.)

Are These Your Only Possibility For Market Gains?

Our government (specifically, Alan Greenspan and the rest of the Fed) is worried about falling prices (deflation) these days. So why should we buy an inflation protected investment? Isn't that like buying flood insurance in the desert?

No, it isn't. The way Greenspan fights falling prices is by creating inflation - by printing money. And the folks at the Fed have stated that they prefer inflation to falling prices. So chances are, in order to make certain to avoid deflation, they'll overshoot as they print money, creating inflation. Higher inflation would crush owners of Treasury bonds, as interest rates rise. But it wouldn't hurt us in our inflation protected securities - we'd just earn even more in interest.

If you had your money in a CD earning 2.0%, higher inflation would crush you as well. You'd be stuck earning a negative "real" return on your money, as inflation eats away at your purchasing power.

So the only real guaranteed investment - absolutely guaranteed to increase your purchasing power no matter what the environment - is an inflation protected security.

You have two good choices:

With the savings bonds, you'll absolutely never have the possibility of losing money. I must say, with the Vanguard fund, it is theoretically possible to lose money briefly. The interest income is guaranteed to be paid and more than keep up with inflation. However, the Treasury Inflation Protected Securities - TIPS they hold will fluctuate up and down in price.

It's up to you, whether you want 4%+ right now in the savings bonds. Or if you prefer to take on a little more risk, then I'd recommend the Vanguard fund. You'll enjoy what have been - and may continue to be - very handsome returns, along with a built-in safety factor that will always pay you interest.

I think a little of both would be appropriate.

Good investing,

Steve

Today's Investment U Crib Sheet

  • For more on inflation protected savings bonds, go to www.savingsbonds.gov (and click on I-bonds). For more on Vanguard's fund, go to www.vanguard.com and use the search function.

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