Inflation Protection for Investment Dollars
For the 12-month period ending in March 2018, the Consumer Price Index for All Urban Consumers (CPI-U), the standard measure of “headline inflation,” increased 2.4% — the fastest pace since March 2017 and significantly higher than the 1.6% average over the past 10 years.1
Looking at the bigger picture, the 50-year U.S. inflation average is 4.1%.2 So the last decade, beginning with the Great Recession, has seen unusually low price increases, but the pace seems to be picking up with the improving economy. The Federal Reserve has been raising the benchmark federal funds rate to guard against future inflation while also moving the rate toward a more typical historical range.3
Eroding Purchasing Power
Even moderate inflation can have a negative impact on the purchasing power of fixed-income investments. For example, a hypothetical investment earning 5% annually would have a real return of only 3% during a period of 2% annual inflation. This rate of return might be further reduced by taxes.
If inflation continues to increase, it could become a more pressing concern for consumers and investors, and might be especially significant for retirees living on a fixed income. One way to help hedge your bond portfolio against a potential spike in inflation is by investing in Treasury Inflation-Protected Securities (TIPS).
How TIPS Fight Inflation
TIPS are sold in $100 increments and are available in maturities of 5, 10, and 30 years. The principal is automatically adjusted twice a year to match any increases or decreases in the Consumer Price Index. If the CPI-U moves up or down, the Treasury recalculates your principal to reflect the change.
A fixed rate of interest is paid twice a year based on the current principal, so the amount of interest may also fluctuate. Thus, you are trading the certainty of knowing exactly how much interest you’ll receive for the assurance that your investment will maintain its purchasing power over time.
Like all Treasury securities, TIPS are guaranteed by the federal government as to the timely payment of principal and interest. If you hold TIPS to maturity, you will receive the greater of the inflation-adjusted principal or the amount of your original investment; this provides the benefit of keeping up with inflation while protecting against deflation. Considering that there has been some inflation every year over the past 50 years, the principal of TIPS held to maturity is likely to be higher than when it was purchased.4
TIPS pay lower interest rates than equivalent Treasury securities that don’t adjust for inflation. The breakeven inflation rate is the difference between the yield of TIPS and nominal (non-inflation-protected) Treasury securities with similar maturities. It is the cost for inflation protection and also a market-based measure of expected inflation. If inflation runs higher than expected, TIPS will earn a better return than nominal Treasury securities. If the inflation rate runs below the breakeven rate, then TIPS have no clear advantage. However, the increased principal due to any level of inflation can still add to the value of your portfolio.
As with all bonds, the return and principal value of TIPS on the secondary market will vary with market conditions. TIPS and other Treasury securities are sensitive to movements in interest rates. When interest rates rise, the value of existing TIPS will typically fall on the secondary market. Because headline CPI includes food and energy prices, TIPS can also be affected — for better or worse — by volatile oil prices. However, changing rates and secondary-market values should not affect the principal of TIPS held to maturity.
You must pay federal income tax each year on the interest income from TIPS plus any increase in principal, even though you won’t receive that money until TIPS reach maturity. For this reason, many investors prefer to hold TIPS in a tax-deferred account such as an IRA.