January 1, 2006, was an important date in history: Not only did early hip-hop pioneer Grandmaster Flash turn 48 years old, but the first of the baby boomers reached age 60. With this historic event, we believe we will begin to see a change of attitude and focus among the newly retired generation–a shift from wealth creation to wealth preservation.
Preserving wealth may not seem as hard as creating it, but it is tougher than most people would believe. Just look at the Forbes 400 list of the wealthiest Americans. Over the 23 years since its inception, only 11% of the original 400 have managed to remain on the list. Over the years, certain issues have caused an erosion of that wealth, including over concentration, over leverage, and family discord.
These factors may well also affect the wealth preservation of your clients. An even more powerful threat to their wealth preservation may be as simple as “inflation.”
I can imagine what you are thinking: “You’re kidding, right?” In the past 10 years, inflation has been low and stable. So why bring this subject up now?
It’s true that inflation has been restrained–within the Federal Reserve’s “comfort range”–and we believe inflation should continue to remain under control in the short term. However, there is no clear-cut argument ruling out an inflation threat in the long term. Although the past may not be an indication of the future, a look at previous U.S. economic conditions shows that inflation can rise suddenly and unexpectedly.
Now may be a good time to have a discussion regarding your clients’ expectations about inflation and to suggest specific ways they can protect themselves in case of any sharp accelerations in inflation.
A question that JPMorgan Asset Management has found useful to spark this conversation is: “How much inflation can you stand before putting your long-term goals at risk?”
Are Your Clients Protected?
Traditionally, investors have hedged against inflation by using such alternative investments as real estate or commodities. But as we see a change in baby boomer attitudes toward wealth preservation, clients with a lower risk tolerance or income-oriented goals may find that Treasury Inflation-Protected Securities (TIPS) and the more recent consumer price index (CPI)-related derivatives may be a better fit.
This article will focus on how TIPS, and their synthetic cousins, may help protect the affluent investor against inflation.
TIPS were introduced to the market about 10 years ago with minimal fanfare. Slowly and quietly they have grown in popularity and now represent about 10% of overall Treasury debt. That amount is expected to rise to about 15% over the next several years. This growth has resulted in more liquidity, transparency, and scalability, which has fostered the growth of the derivative markets (i.e., synthetic inflation hedges).
In the simplest terms, TIPS are a type of Treasury security that offers bond investors protection from inflation by indexing the principal and coupon payment to the U.S. CPI.
For example, if the CPI goes up by 1%, the value of the bond would go up by 1%. Therefore, if we take a $1,000 inflation-indexed bond with a 4% coupon rate and 1% inflation the principal would be increased to $1,010, and the semi-annual interest payment would be $20.20.
In comparison, a normal or “nominal” bond pays its interest on a fixed principal amount, which is repaid at maturity. Inflation is a major risk to a nominal bond holder, since increasing inflation means reduced “purchasing power” in the face of increasing prices.
Thus, because TIPS remove the uncertainty associated with inflation risk, they tend to be less volatile than nominal bonds and generally less volatile than nominal Treasuries. Even so, TIPS are still subject to price fluctuations, which usually occur when real interest rates change. As a result, TIPS’ principal value can move up or down with inflation or deflation, respectively. However, for bonds purchased at new issue and held to maturity, TIPS will pay the greater of the inflation-adjusted principal or par.
Normally, bond investors demand an extra “yield premium” or compensation for inflation risk (see Interest Rate Refresher). Since inflation-linked bonds are not exposed to inflation, their yield is lower than normal or nominal bonds.