One major threat to fixed-income investments—and to the retirees who depend on various kinds of bonds to deliver cash to pay their bills and support their lifestyle—is inflation. When the cost of living rises, a dollar doesn’t go as far as it did before, and your savings may not last as long as you’d hoped. A special kind of investment—Treasury Inflation-Protected Securities, or TIPS—addresses that risk directly, by adjusting bond principal to keep pace with changes in the Consumer Price Index (CPI). Yet while TIPS may have a place in many portfolios, they’re not a cure-all. TIPS are still bonds, and they’re still subject to non-inflation risks that can hurt their value.
TIPS were created in 1997 as a variation on garden-variety U.S. government bonds. Like regular Treasuries, TIPS have a fixed interest rate or coupon that determines how much income they’ll provide until they mature. But the principal of TIPS adjusts up or down every month as the CPI rises or falls. If inflation rises, so does the principal, and the fixed return on that larger amount means additional income for the bondholder. When TIPS mature, the government pays you the adjusted principal (or the original amount, in the unlikely event that the CPI has fallen during the bond’s term).
These bonds’ prices and yields factor in an expectation that inflation will rise. That’s why, recently, the yield on a 10-year Treasury was about two and a half times the yield on a 10-year TIPS. The only reason to accept the much lower current return on the TIPS is if you expect its principal, and thus its effective yield and its total return, to rise significantly during the time you own the inflation-protected bond. If consumer prices rise less than expected, that 10-year Treasury may turn out to have been a better deal.
But mild inflation isn’t the only risk that these bonds bring. Because TIPS are bonds, interest rates are also part of the equation. When real interest rates rise, newly issued bonds will offer higher yields. That reduces demand for existing bonds’ below-market yields, and lower demand translates into lower prices. That’s why it’s often said that bond prices and yields move in opposite directions.
It’s not clear when, and how quickly, inflation may accelerate. But almost everyone believes interest rates are on their way up from what have been very low levels. That means the prices of bonds—including TIPS—will suffer. And while TIPS can help diversify a bond portfolio, and could serve as a hedge against inflation, deciding whether to add them to your investment mix is complicated. We can help you consider your options in light of your financial situation and goals.