May 19, 2009
If you are among those who believe inflation will be the price we pay for expansionary monetary policies and expanding Federal deficits, then Treasury Inflation Protected Securities (TIPS) today present a compelling opportunity.
Even if you number among those who forecast deflation, TIPS are likely to outperform many other asset classes.
As BU finance professor Zvi Bodie noted in a recent article, TIPS are unquestionably the safest inflation hedge for a US dollar-based investor and are arguably the safest investment in the market today – period. All other traditional inflation hedges – equities, gold, commodities, and real estate – may work as a hedge but will introduce other risk factors. TIPS, on the other hand, are a pure inflation hedge.
TIPS are not riskless, and investors need to understand the market dynamics that drive their performance.
TIPS were introduced in the US markets in 1997, although similarly structured securities have been available in non-US markets prior to that. When TIPS are issued, they are redeemable at par with a fixed coupon rate and maturity date. Each month the principal value is adjusted up or down depending on the inflation rate (the government uses the broad-based CPI-U figure with a three-month lag). Coupons are paid semi-annually and are determined by multiplying the coupon rate at issue times the adjusted principal value.
Although the principal value of TIPS can go below par over the life of the bond, their principal value at maturity is guaranteed to be at least par. Because they are protected at par, TIPS a good bet to outperform equities and commodities in a prolonged deflationary environment.
Taxable income from TIPS comes from coupon payments and the adjustment for an increase in principal value (in an inflationary environment). The latter creates a “phantom tax” and the belief that TIPS are tax-disadvantaged, since TIPS owners must pay tax on principal value increases, even though they receive no cash payments from these increases until the bond matures. Principal payments at maturity are not taxable.
TIPS issuance has grown steadily over the last decade, but still comprises a relatively small portion of Treasury issuance – $14 billion in the second quarter of 2009, compared to $327.5 billion of nominal bonds. Initially, TIPS were purchased primarily by pension plans and asset managers whose goal was fund liabilities indexed to inflation, and the TIPS market was relatively illiquid. That problem has disappeared, as TIPS are now broadly owned in retail and institutional portfolios.
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