Investment Strategies

Protecting portfolios against inflation with Treasury Inflation-Protected Securities

TIPS now make up the largest component of the global inflation-linked bond landscape in terms of value

Aug 28, 2009 @ 11:03 am

By T. Anthony Coffey

Nowadays, it is common to hear financial pundits talking about their expectations for inflation.

But what does inflation mean for the average fixed-income investor, and those saving for or in retirement? Simply put, inflation is a rise in the price of goods and services; for example, as inflation rises, a $10 bill today may have less purchasing power next year.

Inflation-linked bonds are one answer to inflation's insidious impact.

The British government pioneered the modern inflation-linked market by being the first sovereign entity to issue such instruments in 1981. Among countries to follow suit included Australia, Canada, France, Germany, Japan, Sweden and the United States.

Since its inception, the market for global inflation-linked bonds has continued to grow and evolve, further strengthening arguments for “going global” with regard to inflation protection. As of July 31, the market capitalization of global inflation-linked sovereign debt was around $1.4 trillion, up 47% from three years ago, according to Barclays Capital Inc. of New York.

Moreover, Treasury Inflation-Protected Securities have recently become the largest component of the global inflation-linked bond landscape in terms of market value, as measured in May by the Barclays World Government Inflation-Linked Index.

In addition to being guaranteed by the government, TIPS have a special feature that provides protection against inflation. The principal value of a TIPS issue is adjusted periodically based on the rate of inflation, as measured by the Consumer Price Index. In contrast, a Treasury bond's principal value is fixed.

TIPS also have a deflationary floor. That means if the securities are held to maturity, investors would be able to redeem the securities at par with the entire principal amount. So at maturity, if the adjusted principal is less than the security's original principal due to deflation, investors are paid the original principal.

Suppose an investor purchases a new 10-year TIPS with a 2% coupon for $1,000. If inflation, based on the reference CPI when the security was issued, is 2.5%, the face value of the security would increase by 2.5% to $1,025, and the semi-annual interest payment would increase to $10.25 to reflect the upward-adjusted principal amount.

At maturity, TIPS are redeemed at their inflation-adjusted principal amount or at par, whichever is greater.

Because of their inflation-adjusted features, some investors may mistake TIPS for adjustable-rate securities, whose interest rates reset periodically and which are therefore less sensitive to interest rate risk. It might be easy to confuse inflation protection with interest rate protection. The fact is, TIPS can be volatile, typically when interest rates rise — an important point to understand before considering an investment in TIPS or a mutual fund that invests in TIPS.

The other wrinkle associated with TIPS is taxes. The inflation adjustment of the TIPS principal amount is subject to federal tax in the year in which it occurs, even though the investor wouldn't realize the adjustment until the security matures. In other words, if a 10-year TIPS with a $1,000 face value increases in value (due to an inflation adjustment) to $1,025, the owner would be liable for federal tax that year on the $25 increase — even though the investor won't see the $25 unless the TIPS issue was sold or redeemed that year.

For mutual fund investors, however, it is a different story. A fund that invests in TIPS typically pays out any income from principal adjustments as part of its regular distributions. These distributions are taxed similarly to dividends received from other income investments.

One thing to remember, though, is that since TIPS make inflation adjustments, the net asset value of a mutual fund that invests substantially in TIPS can decline in deflationary periods. The fund's dividend may also fluctuate dramatically from month to month, as negative inflation adjustments for TIPS in certain months may mean the fund does earn enough net (after fees) investment income to pay a dividend.

Depending on their particular view and risk profile, investors can use various methods to counteract the effect of inflation on their portfolios, including broad diversification across asset classes.

For those approaching or in retirement, preserving the buying power of one's assets is essential. While the long-term inflationary implications of the federal government's stimulus programs are still unclear, TIPS can serve as an important inflation hedge in any long-term prudent asset allocation.

Mutual fund holdings in TIPS are guaranteed by the federal government, ensuring timely payment of principal and interest.

However, a fund's yield and share price are not guaranteed, and will vary with market conditions. TIPS purchased on the secondary market may experience a net loss if purchased above their par value.

The U.S. government does not guarantee against losses incurred on the secondary market.

T. Anthony Coffey is a vice president and portfolio manager at Franklin Templeton Managed Investment Solutions in San Mateo, Calif.

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