Concerned About Inflation? Consider TIPS
Inflation has been relatively low for the last decade, but the economic stimulus packages and recovery from the pandemic are expected to heat up the U.S. economy.1 Even so, the Federal Reserve has indicated it will let inflation run above the Fed’s 2% target for some time before raising interest rates.2
It’s unlikely the Fed will let inflation get out of control, but even moderate inflation can reduce purchasing power and erode the value of your investments over time. Inflation can be especially challenging for retirees living on a fixed income.
Moving with the CPI
One way to help provide protection against inflation is through Treasury Inflation-Protected Securities (TIPS). The principal value of TIPS is automatically adjusted twice a year to match any increases or decreases in the Consumer Price Index for All Urban Consumers (CPI-U). 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 fluctuate. Thus, you are trading the certainty of knowing exactly how much interest you’ll receive for the potential that your investment will maintain its purchasing power over time.
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 typically 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.
In the current low interest-rate environment, TIPS may have negative interest rates that might produce a positive return after the principal is increased for inflation. For example, at the beginning of July 2021, a 5-year TIPS offered a return of –1.60% while a 5-year Treasury note offered a return of 0.89%.3 The 2.49% difference between these rates is the breakeven inflation rate. If inflation were to run at 3%, the TIPS would return 1.40% (3% – 1.60%) after adjustments for inflation, about half a percent higher than the return on the Treasury note.
Eroding Purchasing Power
Over the past 50 years, inflation has averaged almost 3.9%, with wide variations including runaway inflation from 1973 to 1981. More recently, inflation has been lower and relatively consistent, averaging about 2% over the last 20 years. In the spring of 2021, inflation started trending higher.
TIPS are sold in $100 increments and are available in maturities of 5, 10, and 30 years. Like all bonds, the return and principal value of TIPS on the secondary market vary with market conditions, are sensitive to movements in interest rates, and may be worth more or less than their original cost.
When interest rates rise, the value of an existing TIPS will typically fall on the secondary market; when rates decline, the value of a TIPS will typically rise. Changing rates and secondary-market values should not affect the principal of TIPS held to maturity.
All Treasury securities, including TIPS, are guaranteed by the federal government as to the timely payment of principal and interest. 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 they mature. For this reason, it may be preferable to hold TIPS in a tax-deferred account such as an IRA.