Treasury Inflation-Protected Securities for Inflation Protection

March 17th, 2008  |  Published in Retirement  |  4 Comments

If you’re worried about inflation and worried about traditional inflation-busting investments (the stock market, since inflation risk should be priced into the market price of shares), you might want to give Treasury Inflation-Protected Securities, or TIPS, a look. TIPS are simply treasury bonds that make adjustments because of the rate of inflation. The coupon rate of the bond remains the same but the principal is adjusted along with the Consumer Price Index, so you get protection against inflation.

Let’s use an example of how a TIPS would work to help illustrate them. Let’s assume you purchase a $1,000 TIPS bond with a coupon rate of 3%, it’ll pay out 3% interest each year. If inflation came in at a screaming 10% (screaming now, but quite pedestrian compared to the 80s), the principal of the bond increases by 10% to $1,100. The 3% coupon is then calculated using the $1,100 value and not the original $1,000 value.

What happens with a regular bond? That adjustment of the principal or face value of the bond doesn’t occur, so you would only get 3% on the original $1,000.

The difference now is that you won’t be able to buy the two bonds at the same price, the nominal bond should be cheaper because you are assuming the interest rate risk rather than the government.

So, if you’re on fixed income and concerned about inflation, consider TIPS. For more information, visit this Treasury website discussing TIPS.

  

Responses

  1. Lily says:

    March 17th, 2008 at 8:04 am (#)

    TIPS might have been more timely a few months ago. Now, TIPS have negative yield because so many investors have rushed into them on inflation worries. That means investors are paying MORE for TIPS now than they’d get back in total cash flow (coupons + principal).

    This doesn’t make TIPS an unwise investment. These investors are really betting that inflation will be higher than what the Fed thinks it is, as measured by the CPI. So then the question is how well do you think the Fed is predicting inflation? I wouldn’t be so quick to jump on the Fed-hating bandwagon here. It’s easy to complain about sinking yields and weak dollars, but most of the whiners don’t understand how the Federal Reserve System works, much less how not lowering the rates would impact the system.

  2. David says:

    April 4th, 2008 at 4:47 am (#)

    I noted with interest Lily’s response – and as a novice investor would welcome some direction. I am a 65 year old retiree and have had my traditional IRA in one year CD’s since retiring five years ago. Last year I was receiving a 5% return on a “Jumbo” CD (now $132,000), but upon maturity last month the interest rate had dropped to under 3%. I transferred my entire balance to Vanguard Investments upon maturity (currently in Vanguard Prime Money Market Fund) with the intention of investing 100k in the Vanguard TIPS Admiral shares fund (VAIPX) because of it’s low fees and inflation protection. Now I’m questioning the advisability of doing so – I would be interested in other viewpoints. I have not had to take any distributions from my IRA since retiring – S/S (since age 62), pension, and savings have been adequate to support my lifestyle, but inflation is my BIG worry for the future (I remember the 70’s) as my pension has no inflation adjustment. I am a VERY conservative investor interested only in protecting my principal with inflation protection. Any thoughts would be most appreciated!

  3. Charles says:

    March 19th, 2009 at 7:32 pm (#)

    David,

    I would not recommend Vanguard TIPS account for a taxable account. It would be better placed in your IRA. The taxable distribution include both the inflation-part and the regular dividend-part. Check out the Inflation Protection Investor fund (VIPSX) information for the longer history of the distribution. The Admiral fund has a shorter history and because of its lower cost the Admiral fund would have slightly higher returns that the Investor fund.

    Another suggestion: Consider “re-applying for social security”. “Re-apply” means to repay the social security that you have collected to date & then applying again at your current age. For more information, go to esplanner.com and click on “learn more”, “case studies”, and then “reapply for social security”.

  4. Charles says:

    March 19th, 2009 at 7:52 pm (#)

    David,

    Should have added the advantages of “re-applying”. This sets your monthly SS payment at a higher level and this payment is subject to the normal SS inflation adjustment.
    Also, note that the “re-payment” does not include any interest only the SS payments you collected.

    The ‘reduction percentage’ for someone born 1943-1954 is 25%. This means if full retirement would be $1000 then age 62 retirement would be $750. The ‘repayment’ thus would increase the benefit by 33% (i.e. 250 / 750). Not bad! Also, another 8% for each year past full retirement.

    Read the article and then work your numbers and see if it
    addresses your problem.