Q: I’ve been reading a lot about potential inflation concerns and also about something called “TIPS” as an investment idea for this. Can you please help me understand how these work?
A: Yes, there has certainly been plenty of talk recently about whether or not we may see more inflation in the coming months and years. Here’s a bit more information about TIPS: what they are, and why they may be an option for some.
Remember inflation — that nasty beast that plagued the U.S. economy in the ’70s and ’80s, driving prices up more than 10 percent a year and wreaking havoc with financial markets?
For most Americans, high inflation may be only a distant memory, at least in the U.S. In fact, the last time the Consumer Price Index registered an annual increase above 4 percent was in 1991 — more than 25 years ago.1 And in the five years ending Dec. 31, 2017, it averaged only 1.4 percent.
Lately, there have been growing concerns about mounting inflationary pressures. A thriving economy, a tight labor market, a housing boom, the stimulative effects of the $1.5-trillion tax cut passed in December and, most recently, the prospect of a trade war all put upward pressure on prices. In January, the CPI spiked to a seasonally adjusted .5 percent for the month — which, if the trend continued, would put annual inflation considerably above the fed’s target rate of 2 percent. Although the monthly increase dropped down to .2 percent in February, many economists see an eventual uptick. The Federal Reserve has already been applying the brakes, with six increases in the federal-funds rate since late 2015, including a .25-percent hike in March.
But even at moderate levels, inflation can still take a toll on investments over time. Consider that the purchasing price of $1,000 would erode to just $744 if subject to 3-percent inflation over 10 years. So, for investors, especially retirees and others depending on fixed-income investments, inflation is a real concern.
TIPS to the rescue
In an attempt to protect fixed-income investors from inflation, the Treasury Department issues inflation-indexed bonds called Treasury Inflation Protected Securities (TIPS) in five-, 10- and 30-year maturities with a return linked to the inflation rate. These bonds are available for purchase in $100 increments through financial advisors, banks and Treasury Direct (www.treasurydirect.gov).
The benefits of TIPS include:
• Rate of return is guaranteed to exceed the rate of inflation.
• Principal is indexed to the CPI.
• Semiannual interest payments are based on the interest rate applied to the inflation-adjusted value of the principal.
• Guaranteed return of the principal even if the rate of inflation drops.
The drawbacks of TIPS include:
• If sold before maturity, prices can be volatile, varying with interest-rate changes.
• TIPS are less liquid than ordinary treasuries.
• Interest payments on TIPS will vary, depending upon the inflation adjustment.
• Although the principal is adjusted for inflation, TIPS typically pay lower interest rates than treasuries with comparable maturities.
How do TIPS compare with traditional treasury bonds? Assuming the inflation rate is 3 percent and the yield of an unindexed $1,000, 10-year treasury note is 5 percent, the real yield of this note would be 2 percent (5 percent minus the inflation rate). After a year, an investor would gain $50 of interest but be ahead by only $20 because of the effect of inflation.
In general, it makes the most sense to purchase TIPS if you expect a major uptick in inflation. Whether that scenario is in the offing at this time is unclear. But if inflation does rear up, TIPS could be a viable alternative to consider.
1Federal Reserve Bank of Minneapolis, Consumer Price Index, 1913-Present.
Bonds are subject to market and interest rate risk if sold prior to maturity. Although the interest that inflation-indexed bonds pay is exempt from state and local taxes, federal income taxes apply. You are required to pay taxes on the interest and any increase in principal on an annual basis.
This article was prepared with the assistance of DST Systems Inc. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Please consult me if you have any questions. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.
Because of the possibility of human or mechanical error by DST Systems Inc. or its sources, neither Wealth Management Systems Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall DST Systems Inc. be liable for any indirect, special or consequential damages in connection with subscribers’ or others’ use of the content.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity
*As reported by Financial Planning magazine, June 1996-2017, based on total revenues.
**Award based on 10 objective criteria associated with providing quality services to clients such as credentials, experience, and assets under management among other factors. Wealth managers do not pay a fee to be considered or placed on the final list of 2017 Five Star Wealth Managers.