Are TIPS Really Safe and Worry-Free?

Here is the first in what will be a monthly column by Wade Pfau on topics related to de-accumulation strategies and safe withdrawal rates. 

The Fed’s aggressive monetary easing has many investors considering Treasury inflation-protected securities (TIPS) as a cornerstone of their retirement strategy.  While TIPS’ unique ability to protect against CPI-based inflation is undeniable, many investors neglect to consider the risks they pose, particularly for those who have not yet reached retirement.

The U.S. began issuing TIPS in 1997. Backed by the full faith and credit of the U.S. government and assurances that inflation cannot eat away at their value, TIPS seemed to be a truly risk-free asset for U.S.-based investors. In 2003, Zvi Bodie and Michael J. Clowes published the book, Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals, in which they argued that typical retirement-oriented investors should rely primarily on TIPS for their retirement savings. Other financial assets should be included in the retirement portfolio only once one has enough savings (after accounting for any income expected from Social Security and other defined-benefit pensions) to cover their planned retirement expenditures without these riskier assets. In an interview in the February 2010 issue of Journal of Financial Planning, Bodie confirmed his continued endorsement of this strategy. He also indicated that his personal retirement portfolio is 100% in TIPS.

Let’s take a critical look at the safety of TIPS. To be clear, I do accept the arguments made by Bodie and others that it is fallacious to believe that stocks are less risky than bonds, even when held over long periods of time. And I don’t believe, as some do, that investing in TIPS is foolishly conservative in light of the historical risk premium provided by stocks.  TIPS can play an important role in most retirement portfolios. But Bodie and Clowes’ strategy is not the no-brainer they make it out to be. Like other assets, TIPS have risks and do not eliminate the need for broad diversification.

1. TIPS have greater default risk than nominal government bonds

The conventional wisdom is that U.S. government debt carries negligible default risk. Because the dollar is the world’s reserve currency, the government can easily issue bonds denominated in dollars. The U.S. can avoid default by 'printing money' as the Federal Reserve buys U.S. Treasury bonds from the open markets, paying for their purchases by crediting the sellers with newly created bank reserves. Yes, we learned this summer that Congressional gridlock with regard to raising the debt ceiling could lead to a technical default, and, yes, there is an active credit default market for U.S. government debt – but, for now, let’s set these issues aside.

The default risk for TIPS, however, is actually greater than the default risk for traditional Treasury bonds. This is because, all things considered, issuing TIPS has more in common with issuing foreign-currency bonds than issuing domestic-currency bonds. TIPS owners will not necessarily get a free pass should inflation pick up in the coming years. Printing money to pay interest and principal on government debts will trigger inflation, which in turn raises the nominal value of payments the government must make on TIPS. Just as a country that borrows in a foreign currency cannot print money to pay its debt –  printing money will only trigger depreciation of their exchange rate and make their debt obligations harder to meet – the U.S. government will not be able to print money to escape its obligations to TIPS investors.

History is full cases in which countries have defaulted on their foreign currency-denominated debt. To avoid an embarrassing outright default, the federal government could redefine the inflation measure downward in order to reduce its debt obligations, in which case TIPS owners may not receive adjustments appropriate for the actual rising costs of living. This would be a significant source of worry for individuals who primarily rely on TIPS to finance their retirement.