TIPS offer a safer investment opportunity and a way to preserve capital during uncertain economic times when inflation and possibly hyperinflation are on the horizon.
Safe Investing is the New Norm
The name of the game for investors during the past year has been to preserve capital at all costs. This need to preserve capital was so intense that in December 2008, investors bid the 3-month treasury bills into negative territory for the first time ever. With financial pundits foretelling the coming of inflation and some economic scholar predicting hyperinflation, many investors have begun to exit the safe-haven investment world of short-term treasury bills and demanding higher interest rates for the longer 10-year and 30-year bonds. With the added uncertainty about the resurrection of the American consumer to support the stock market, investors who continue to seek a safe investment and capital preservation may want to consider investing in Treasury Inflation-Protected Securities (TIPS).
What are TIPS?
TIPS are government bonds that offer risk-aversive investors the safety of a United States security and protection against the erosion of their investment by inflation. TIPS are structured to adjust the principal whenever there is a change in the inflation as measured by the Consumer Price Index (Urban CPI-Urban, Non-Seasonally-Adjusted with a 3-month lag).
During times of inflation and deflation, the principal is adjusted upwards or downwards accordingly. The CPI index ratios for each bond sold can be found in the monthly tables published by the the United States Treasury.
The CPI ratio is used to adjust the principal, which in turn is used to determine the amount of interest which is paid during the bond’s life. Interest is paid semiannually and is determined by the fixed interest rate received at the time of purchase of the bond and the adjusted principal at the time of the interest payment.
Interest Payment = Fixed Interest Rate/2 x CPI Index Ratio for Month and Date of Interest Payment x Investment Amount
How to Buy TIPS?
TIPS are sold with different maturities throughout the year on a set monthly schedule. Each security has an initial offering month and then a reoffering month six months later when the security is sold again with the same maturity date, interest rate, and interest payment dates as the original security. What will change is the issue date and the price which depends on market conditions and the expectation of inflation. The current periodic schedule provides the opportunity for investment during each quarter as follows:
- 5-year TIPS are initially offered April and then reoffered in October.
- 10-year TIPS are initially offered in January and April and then reoffered in July and October, respectively.
- 20-year TIPS are initially offered in January and then reoffered in July.
The cheapest and safest way to buy TIPS is through Treasury Direct by establishing an individual account online. TIPS can be purchased in $100 increments, which is another incentive for conservative investors to assume some risk and dip into their cash holdings. You can also purchase TIPS through banks and brokers or invest in ETFs, such as iShares Barclays TIPS Bond ETF or in inflation-indexed mutual funds, such as Vanguard Inflation-Protected Securities Fund Investors Shares (VIPSX) . These options are good if you want to keep your investments centralized for record-keeping purposes with your broker or you want to wrap your investments into an IRA or 401K for tax purposes. The optimal time to buy TIPS aggressively is before the market has priced in the expectations of inflation or hyperinflation. However, finding early signs of inflation is not an easy task. The best strategy for conservative investors seeking protection against future inflation is simply to begin to build a position in TIPS while inflation expectations are still tepid. TIPS may not be the hot stock tip investors are looking for, but they provide an opportunity on a safe bet that inflation will certainly return during the next 20 years.