TIPS for Fighting Inflation

As signs of inflation creep back into the economy, some investors may seek to protect their portfolios from higher consumer prices.

Traditionally, investors have flocked to defensive equity sectors — such as consumer staples, utilities, materials, energy and health care — to escape the threat of inflation. Sam Stovall, chief investment strategist at Standard & Poor’s, notes that these industries tend to outperform the market during periods of rising inflation.

In addition to a range of mutual funds that invest in these sectors, there are a number of exchange-traded funds (ETFs), including S&P Select Consumer Staples SPDR Fund (XLP), S&P Select Utilities SPDR Fund (XLU), S&P Select Materials SPDR Fund (XLB), S&P Select Energy SPDR Fund (XLE), S&P Select Health Care SPDR Fund (XLV), that investors can also employ to make tactical asset allocation decisions. All are traded on the American Stock Exchange, and each represents a particular segment of the S&P 500.

However, another strategy might be to invest in fixed-income securities, particularly Treasury Inflation-Protected Securities, or TIPS, which are bonds issued by the U.S. Treasury Department designed to ward off the deleterious effects of inflation, which hits fixed-income investors particularly hard. Launched in 1997, the U.S. TIPS market currently totals about $275 billion, representing a tiny portion of the fixed-income universe, but about 5% of the U.S. Treasuries market outstanding.

Presently, there are fewer than two dozen mutual funds exclusively focused on inflation-protection using TIPS. There is also one exchange-traded fund dedicated to investing in TIPS — the $2.3-billion iShares Lehman Brothers TIPS Bond Fund (TIP). Introduced in December 2003, this ETF seeks to match results the price and yield performance, before fees and expenses, of the Lehman Brothers U.S. Treasury Inflation Notes Index.

What Are TIPS?

When an investor owns a TIPS security, the principal amount is periodically adjusted to keep pace with inflation, as measured by the Consumer Price Index (CPI). TIPS provide investors with a haven from inflation, as well as a “real return” over inflation throughout the investment period. For example, if the CPI goes up by 0.7%, the value of the TIPS bond would also climb by 0.7%. If the CPI were to fall, the bond’s value would not decline too much since the government guarantees the original investment will remain the same.

At maturity, the TIPS bond is redeemed at either its inflation-adjusted principal amount or its original par value, whichever has greater value. However, since inflation is likely to take place over the life of the security, the payment to the holder will probably be greater than the bond’s original par value. The rate of interest on the TIPS is applied to the inflation-adjusted principal, not to the par amount. Moreover, since TIPS are primarily issued by the Treasury Department, their repayment is guaranteed by the federal government and they feature negligible credit and default risks.

John Hyll, co-manager of the $10.4-million Loomis Sayles Inflation-Protection Securities Fund (LSGSX) notes that the attractiveness of TIPS as investments depends on the market’s expectations for inflation, and whether or not such forecasts materialize. The key ingredient in determining the appeal of TIPS lie in their relative price to regular (or nominal) U.S. Treasuries — specifically, the difference between the yield on TIPS and the yield of a regular Treasury of similar maturity. To illustrate, the yield on the 10-Year TIPS currently amounts to 1.6%, while the yield on 10-Year Treasury is about 4.3%. This means that the annual rate of inflation over the next decade has to exceed 2.7% for the TIPS security to outperform the comparable Treasury Note.

TIPS can also make a good component to a diversified portfolio, given that they have poor correlation with the performance of other bonds as well as stocks. However, while TIPS may appear to be a foolproof investment, they carry some risks. For one thing, to receive the full guaranteed real return, a TIPS security must be held through maturity, otherwise short-term swings in the real yield could hurt TIPS’ overall performance. In addition, the interest rate paid by TIPS is lower than that of similar Treasuries securities.

Like other Treasuries, TIPS’ interest earnings are exempt from state and local income taxes. However, TIPS owners are subject to federal income tax on interest payments in the year they are received, and on the growth in principal in the year that it occurs. If inflation is low, TIPS would likely underperform regular Treasuries; in the unlikely event of deflation, the value of TIPS would plunge, though holders would be guaranteed to receive no less than the security’s original par value.

Inflation: Benign, or Cause for Worry?