TIPS for Inflation and Deflation

What are TIPS?

Treasury Inflation Protected Securities (TIPS) are a special type of note or bond issued by the US Department of Treasury. TIPS made their debut on Jan 29, 1997 as investment instruments whose main function was to provide protection against inflation. The principal is linked with the rise and fall of consumer price index, a commonly used yardstick for inflation. Like any other treasury bond, interests are paid semi-annually and the adjusted principal is repaid on maturity. But here, the principal is automatically increased to negate the effects of inflation. And the interest is calculated on the inflated principal rather than the original principal. Thus TIPS provide a means to achieve "real" return over an investment horizon and a guaranteed protection of purchasing power.


An Example Please!

To keep it simple, lets say that all transactions will happen at year end (instead of semi annually). Now, let us assume that our friend John purchased a Certificate of Deposit for $100 on Jan 01, 2013. It promised to give him a 5% interest after 1 year on maturity. So on Jan 01, 2014 he will receive $105.

Did someone say inflation? Ok let us include it by throwing in a 3% annual rate of inflation for 2013. Due to 3% inflation goods worth $100 in Jan 2013 now costs $103 in Jan, 2014. As a result, $105 in Jan 2014 will have a purchasing power of ((100/103)*105 =) $101.94 as on Jan 2013. So John's real yield, will be 1.94%.

On the other hand John's girlfriend Mary invested $100 in TIPS with an annual yield of 3%. She will receive $3 as interest on her original principal of $100. But her principal should get adjusted for 3% inflation since it is a TIPS bond. It will increase to $103 to maintain the purchasing power of $100 as of Jan, 2013. Thus she will end up with $106 which is same as ((100/103)*106 =) $102.91 on Jan 2013. So Mary's real yield will be 2.91%.

Excuse me, what happens to my TIPS during deflation?

This is an interesting question. In the event of a deflation the principal would be decreased to compensate for the drop in the inflation index. The interest payment would decrease as well since it is calculated on the adjusted principal. In extreme deflation there may not be any interest payment at all! This sounds rather grim doesn't it?

Not really because the US treasury guarantees to repay us on maturity either the adjusted principal or the original principal, which ever is greater. Now that is truly a buffer for the downside.

Taxes

There could be interesting tax implications during periods of deflation. Here is an excerpt from the prospectus of Vanguard Inflation-Protected Securities (VIPSX). It is a bond fund that invests primarily in TIPS.

"Return of capital is the portion of a distribution representing the return of your original investment in the Fund. Return of capital reduces your cost basis in the Fund’s shares, and is not taxable to you until your cost basis has been reduced to zero. During periods of deflation, the Fund’s inflation-indexed bonds may experience a downward adjustment in their value. If the downward adjustment more than offsets the income earned by the bonds, the adjustment may cause a portion of the dividends previously distributed to shareholders and classified as income to be reclassified as return of capital."

Such adjustments can get complicated involving filing of amended returns. To simplify the process we feel it is better to hold TIPS investments in tax exempt accounts such as Roth IRA. Since all earnings are tax free in a Roth IRA, it releases us from all headaches arising due to adjustments.

Key facts

Here is a list of important facts excerpted straight from the source, treasurydirect.gov:

• TIPS are issued in terms of 5, 10, and 20 years.
  
• The 20-year TIPS is no longer sold in Legacy Treasury Direct, but it continues to be available in TreasuryDirect.
• The interest rate on a TIPS is determined at auction.
• TIPS are sold in increments of $1,000.
  
• The minimum purchase is $1,000.
• TIPS are issued in electronic form.
• You can hold a TIPS until it matures or sell it in the secondary market before it matures.
• In a single auction, an investor can buy up to $5 million in TIPS by non-competitive bidding or up to 35% of the initial offering amount by competitive bidding.

How to invest in TIPS?

Of course one may purchase them directly from the US treasury or through brokers. However buying directly is not so simple and brokers charge hefty fees.

We feel that a better and smarter strategy is to purchase ETFs or mutual funds that invest in TIPS. Apart from convenience and low management fees, this strategy provides liquidity as well.

Our Experience: After much thought we have added Vanguard Inflation-Protected Securities (VIPSX) to our own portfolio. It has been performing reasonably well. ETF enthusiasts may consider iShares Lehman TIPS Bond (TIP) as an alternative.

Conclusion

We all treat the U.S. Treasuries as one of the world's safest investments. Along the same line, TIPS may be hailed to be the safest of the safe. This safety comes with a cost though. Returns offered by TIPS are lower as compared to other treasury bonds with a similar maturity period.

Currently many pundits are of the opinion that we have entered into a period which will have a slow rise of inflation. Hence it makes sense to have a percentage of our assets protected against inflation. More so, for retirees looking forward to a steady income source with a certain purchasing power in mind.

Reference(s): US Treasury

Image Source(s): iStockPhoto

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