TIPS: They’re not the silver bullet to fight inflation

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Ted Schwartz

Ted Schwartz

Inflation is the bane of wealth accumulation. Over time, it reduces buying power. This is why people, especially retirees, are always searching for ways to keep inflation from whittling away at their money.

In 1997, the U.S. government introduced a new variety of Treasury bond that was welcomed by investors as a solution to the inflation problem. This new form of government debt was called Treasury Inflation-Protected Securities (TIPS).

These investments pay investors two interest rates: a rate fixed for the life of the bond and another rate based on inflation. As it does with other Treasury bonds, the government adjusts the fixed rate periodically for new issues, based on various economic factors. The inflation-based interest rate varies on new and existing TIPS according to the urban consumer price index (CPI-U). So if you own TIPS and inflation spikes, the government pays you more interest to cover this.

TIPS grew quickly in popularity, and were praised for years as an inflation solution that would stand the test of time for new investors. But currently, TIPS are a different story entirely, ironically because they became so popular so fast. The relatively short, happy popularity is an object lesson in the effects of demand on pricing and how there is no silver bullet for fighting inflation.

Initially, TIPS paid a healthy fixed (non-inflation) rate. For example, early on, issues of TIPS were offered in the low single digits, considered to be all gravy because of the inflation-based rate. Inflation has generally run well under 3 percent during the 16 years of TIPS’ existence. So, with this historically low rate during TIPS’ lifetime, there hasn’t been much inflation to be protected from.

Yet, it’s the inflation-based interest paid that has spurred demand for TIPS by retirees, because you never know what will happen to the economy several years out and inflation spikes can be devastating for people on fixed incomes. A traditional U.S. Treasury bill might offer a higher yield but no adjustment for inflation. Compared with regular Treasuries, TIPS were viewed as a worry-free investment.

Sounds pretty good, right? Maybe too good. TIPS’ virtues prompted economists like Zvi Bodie to suggest in 2009 that people should put 100 percent of their retirement savings into TIPS.

Of course, your mother taught you not to put all of your eggs in one basket. But this classic caveat didn’t discourage the ensuing demand for TIPS by investors. The demand grew so great that the government no longer had to offer attractive yields (the fixed or non-inflation rate) to get people to buy them, and these rates went down.

But what if the fixed rate offered on new TIPS goes so low that it enters negative territory? Then there would be no actual yield to protect from inflation, and investors would be getting net returns lower than inflation. This would remove TIPS’ key advantage.

Well, that’s exactly what happened last year amid a slide in bond values. In July 2012, new TIPS had a non-inflation rate of minus .637 percent.

Since then, this rate has edged back into positive numbers — barely, less than 1 percent. As low fixed rates discourage demand, the government will have to increase this rate to get people to buy TIPS.

Investors holding less-than-inflation-paying TIPS — apparently so fearful of big losses from sharp inflation spikes that they’re willing to take a slight loss in return for marginal capital preservation — are paying the government to hold their debt.

If you hold long-term TIPS with a decent fixed rate, you’re probably in good shape. If not, you could be in for some pain.

It can be difficult to unload TIPS with undesirable fixed rates before maturity (to avoid the full brunt of reduced buying power that hits you if you hold on to them). When the fixed (non-inflation) rate on new TIPS goes up, investors seeking to sell existing, low-paying TIPS naturally get less for them.

The story of TIPS reflects two realities. One is the effect of demand on bonds. Unlike stocks, you don’t pay more, you get less (lower yields). The other is that no investment can be counted on perennially as effective protection against inflation.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group in Colorado Springs (capstoneinvest.net), advising individual investors and endowments. He can be reached at ted@capstoneinvest.com.