The surge of borrowing in both the United States and abroad has raised serious interest rate and inflation concerns for many investors. The government will have to offer higher and higher interest payments in order to keep our bonds competitive and attractive, they reason, and this will inevitably push interest rates up. Although the current high unemployment rate makes core inflation — driven by wage increases and rising commodity prices — seem a somewhat distant worry, longterm investors have legitimate concerns about inflation in the future and the damage it can do to investments and purchasing power.
So, what investment policy or strategy is most effective in an inflationary environment? Gold is often considered an inflation hedge, although in the short term it can be pretty imprecise. One very effective means of hedging against inflation became available to investors when the government began issuing Treasury Inflation Protected Securities, or TIPS.
TIPS are specifically designed to provide inflation protection. Unlike ordinary bonds, whose maturity value is fixed, the maturity value of TIPS is adjusted according to changes in the consumer price index. When the CPI rises, the principal of a TIPS increases. Conversely, when the CPI decreases, the principal of the bond does the same. At maturity, you receive the adjusted principal or the original principal, whichever is greater.
Since TIPS have a fixed coupon rate, the interest payments will also increase (or decrease) with changes in the CPI. Here’s a simple example. You own a $10,000 TIPS with a 2% coupon. Your initial annual interest payment would be 2% of $10,000, or $200. During the following year, the CPI increases by 3%, so your new bond principal becomes $10,300. Your coupon rate is still 2%, but it is now applied against the new inflation-adjusted principal of $10,300, so your new interest payment is 2% of $10,300, or $206.
TIPS are issued in maturities of 5, 10 and 30 years and increments of $100, with the initial interest rate determined by auction. They can be purchased directly through the US TreasuryDirect program, or through banks, brokers and bond dealers on the secondary market.
You should also be aware of the special tax treatments of these bonds. While the current interest portion is paid to you each year and taxable that year, the change in value due to the inflation component is also taxable the year it is received, although no payment is involved. Investors can avoid this “phantom tax” problem by holding TIPS in a sheltered account such as an IRA. Additional information can be found on the government’s web site at www.treasurydirect.gov.
Steven Weber is the registered investment advisor of the Bedminster Group, a fee-only advisor providing investment and financial counselin the Lowcountry since 1997. The information herein was obtained from sources considered reliable. Their accuracy cannot be guaranteed. The opinions expressed are solely those of the author and do not necessarily reflect those from any other source.