Key Points:
- Treasury Inflation-Protected Securities (TIPS) are government bonds designed to provide a return that outpaces inflation.
- TIPS can have tax drawbacks, as both the interest payments and the inflation-based principal adjustments are taxable.
- The market value of TIPS can fluctuate significantly, and they lost value in 2022 despite high inflation.
- While TIPS can be a valuable part of a portfolio, they are not a single solution for all investment risks.
Q. TIPS provide a guaranteed return over inflation. As a conservative investor, that sounds good. Is just putting my nest egg in TIPS the way to go? — Bob in Merritt Island
A. Bob, TIPS have a lot going for them. Staying ahead of inflation is important, and TIPS can help. But few people are in a situation where putting their entire nest egg in TIPS is the best move.
“TIPS” are Treasury Inflation-Protected Securities. They are U.S. government-issued bonds that pay a guaranteed rate of interest, called a coupon. The government periodically increases the principal value of the bond based on the observed inflation rate. The stated coupon rate is then applied to this higher principal value, increasing the dollar amount of the interest payments.
For instance, a newly issued bond with a principal value of $1,000 and a 2% coupon will pay the bond owner $20 in interest per year. If inflation came in at 3% for the year, the principal amount of an inflation-protected bond would rise to $1,030, and the interest payment would become 2% of that principal amount or $20.60. Such a bond is said to have a guaranteed 2% real return. “Real return” is a finance term meaning the return above the inflation rate. Note: In practice, principal and interest are adjusted every six months.
A significant potential drawback with TIPS is the tax treatment. In a taxable account, not only is the $20.60 of interest taxable as ordinary income, but so is the $30 inflation adjustment. The owner receives only $20.60 in interest but pays tax on $50.60 of income. That means a Florida resident in the highest federal tax bracket would pocket less than $1.88 cents of after-tax cash flow from their $1,000 investment. High-income taxpayers in other states with a combined federal and state rate of 41% or more would have no spendable cash flow and would need to dip into other accounts to cover the tax bill. This is why TIPS are most often bought in IRAs and other retirement accounts.
TIPS and stability: What’s the verdict?
Another issue is that TIPS can fail to provide the stability and certainty conservative investors crave.
TIPS are not nearly as stable as savings accounts or other conservative holdings like money markets. While TIPS pose no default risk because they are backed by the full faith and credit of the U.S. government, once they are issued, their market value fluctuates based on market forces. Those forces often move prices in counterintuitive ways.
For several years following the 2008 financial crisis, TIPS prices reached historically high levels even though inflation was low. Some TIPS were selling for such high prices over the underlying principal value that their guaranteed real yields were actually negative.
On the other hand, in 2022, inflation hit a 41-year high of 9%, but TIPS did poorly. “TIP,” an exchange-traded fund holding only TIPS with a weighted average maturity of 7.3 years, lost 12.25% of its value that year. So, while TIPS provide certainty about the real interest rate payable over the lifespan of the bond, they clearly do not offer certainty about a bond’s value between the date of purchase and its maturity date.
TIPS are also not immune to reinvestment risk. As I write this, we know we can get a little over 2% in real interest from an inflation-protected bond maturing in five years and nearly 2.5% for a 10-year bond. However, no one knows what rates on similar bonds will be in 2031 or 2036 when those bonds mature and the proceeds need to be reinvested. That’s reinvestment risk.
If you want to reduce reinvestment risk, you can buy TIPS with up to a 30-year maturity. Those currently guarantee a real rate of 2.9%, but the longer the maturity, the more volatile bonds become. For instance, TIPS maturing in 2051 lost 25% to 30% in value in 2022.
TIPS are unique because they guarantee a real rate of return. They can be a valuable addition to a portfolio, but like all other types of investments, they come with challenges. My whole career, people have been looking for that one thing that would take care of all the risks they face. Risk comes in too many forms for that to be realistic. The best risk management approach has been, and should remain, a well-built, broadly diversified portfolio, managed with discipline and patience.
Dan Moisand, CFP® has been featured as one of America’s top independent fee-only financial planners for retirees and near retirees by at least 10 financial planning publications and practices at one of America’s most decorated independent firms. For more info, e-mail him at dan@moisandfitzgerald.com, visit moisandfitzgerald.com, or call Dan at 231-253-5400, ext. 101.
Originally published on FloridaToday. Read the original article here.