Protecting your fixed-income portfolio from inflation
Many readers have asked me whether investing in Treasury inflation-protected securities (TIPS) makes sense. These securities are issued by the U.S. Treasury. The principal invested is indexed to the consumer price index (CPI) to protect you against inflation.
You can buy them directly from the Treasury Department or indirectly in exchange-traded funds and mutual funds. Maturities are five, 10 and 30 years. If you purchase these bonds directly and hold them to maturity, your principal is protected, and you will never receive less than the principal invested.
TIPS pay interest twice a year. There are two factors: a fixed rate established by the Treasury every six months and the increase based on changes in the CPI. In 2021, the fixed rate was .125% for all three maturities. The CPI increased a great deal in 2021 — 3.88% on an annual basis through the end of August.
If the annual increase in the CPI in a year was 4% and the fixed rate was .125, your principal would have increased by 4.125%. If you invested with the Treasury, your principal would have increased in value semiannually. If you invested in ETFs or mutual funds, you would receive the dividend semiannually. The dividend you receive from the ETF/mutual fund would be taxable at ordinary income tax rates. If you purchased the TIPS from the Treasury, the increase in the value of your principal would also be taxable at ordinary income tax rates. If you maintained the investment in a retirement account, which I recommend, the income tax would be deferred.
Returns from investing in TIPS are sometimes better than those from other conservative investments. For example, if the rate of return from a 10-year Treasury note was 2% (actually, it was less than that in 2021), then an investment or in TIPS would have done better in 2021.
You should not look at TIPS investment as a way to obtain high returns; this investment is a way to protect yourself from the loss in purchasing power because of inflation. In periods of low inflation, you will not obtain high returns. When inflation is higher, as it has been in 2021, then the return from TIPS will likely be higher than that of other conservative investments, such as Treasury bills, Treasury notes, money market funds or CDs.
If you consider investing in TIPS, it should be as a part of your fixed-income portfolio. It is no substitute for investing in equities. The long-term return from equities will likely continue to be greater than the return from TIPS.
Most TIPS investors buy them in the form of ETFs or mutual funds, as opposed to purchasing them directly. The advantages are professional management, diversification, convenience and automatic reinvestment. It is convenient because you don’t have to restrict yourself to a specific maturity, and there are fewer restrictions regarding your investment amount.
There are some disadvantages of indirect investment as well. When you buy shares through an ETF or mutual fund, there is no fixed maturity date, so you run the risk that when you sell your shares, you might not receive back more than you invested. The value of your shares can be especially volatile during periods of increases in interest rates.
In order to minimize this risk, you should restrict your investments to an ETF or mutual fund with short maturities. For example, an investment with Vanguard’s VTIF (an ETF) has a current effective maturity of 2.7 years, which minimizes volatility. The return from VTIF last year was 5.48%; for the last three years the return was 4.56%. Fiveyear returns were much smaller because of much lower inflation rates. Other ETFs have slightly higher returns because of longer maturities, but also more risk.
Another disadvantage if you purchase from ETFs or mutual funds is higher costs. However, in general, the annual costs from most financial institutions are relatively low. For example, Vanguard’s annual expense ratio for VTIF is 0.05%.
The bottom line: If you expect inflation to stay at current high levels, then a small investment in TIPS, as part of your fixed-investment portfolio, can provide you with some inflation protection.