TIPS for investing in a time of inflation
Many investors are looking for conservative investments that will protect them against inflation. The recent fall in the stock market has many investors on edge, so they are looking for safe investments that will provide some protection of their asset base.
There are a few investments that investors expect will provide them some protection, namely Series I savings bonds [see “A good time for inflation-protected bonds” in the February Beacon], and mutual funds and exchange-traded funds that invest in Treasury Inflation Protection Securities (TIPS).
Series I bonds and TIPS are designed to protect investors against increases in inflation because their returns are linked to the consumer price Index (CPI).
Unfortunately, some investors in TIPS via mutual funds and ETFs have found the value of their underlying shares recently dropped significantly in value as interest rates have risen.
That’s because, in general, for bond funds there is an inverse relationship between prices and interest rates. That is, when interest rates go up, the prices of bonds, and bond funds and ETFs, go down. [See more at “Some bond alternatives to consider now” from the April issue.]
Be careful where you buy
Note that there is a distinction between buying TIPS directly from the Treasury at TreasuryDirect.gov and buying TIPS in the form of shares from mutual funds or ETFs.
You can purchase TIPS from the Treasury for terms of 5, 10 or 30 years. You may hold them to maturity or sell them before maturity. Your principal will increase in value based on the CPI. At maturity, you are paid either the adjusted principal or the original price, whichever is higher.
Interest is earned twice a year at a fixed rate which is applied to the adjusted principal. So, if your principal increases because of an increase in the CPI, the interest earned would also increase.
However, the interest is taxable in the year earned — even though you won’t receive the interest until maturity if you purchase the TIPS directly from the Treasury.
You could also purchase TIPS mutual funds and ETFs from a financial institution, but they would not have fixed 5, 10 and 30-year terms. [Instead, the fund’s return would reflect a mix of the maturities of the TIPS it purchases.]
The advantage is that you would actually receive the interest paid semi-annually. However, there is a major disadvantage: You no longer have the protection of principal you get when you purchase TIPS directly from the Treasury and redeem them at maturity.
When you purchase shares in the form of mutual funds and ETFs, there is no maturity date. Your shares will fluctuate in value, and when interest rates increase your shares will likely fall in value.
Recent investors got burned
This has already happened this year, and I have received mail from investors complaining about the recent fall in prices. Many of them were under the false impression that, because TIPS returns are based on the CPI, their principal would also be protected and they would be receiving a positive return.
That has not been the case for short-term investments in TIPS mutual funds and ETFs in 2022, so these investors are facing unanticipated losses.
The bottom line is that investors in TIPS who want to be sure their principal is protected should ONLY purchase TIPS directly from TreasuryDirect.gov and should hold them to maturity. For example, the total return of 10-year TIPS in 2021 was 5.5%.
Most investment advisers expect the Federal Reserve to continue increasing short-term interest rates in 2022. So it is expected that investors in TIPS funds and ETFs will likely see a negative return on these investments.
If you had invested in these funds in prior years, you would have received good results for three and five prior years, and modest positive returns for the past year.
But recent investors in these vehicles are now seeing negative returns. Year-to-date returns for many of these has been -3%.
Contact TreasuryDirect.gov for more information about these investments.
Elliot Raphaelson welcomes your questions and comments at firstname.lastname@example.org.
© 2022 Elliot Raphaelson. Distributed by Tribune Content Agency, LLC.