Treasury Inflation Protected Securities (TIPS) – An Important Component of a Diversified Investment Portfolio

You may have heard investors refer to a type of investment called “TIPS.” The term refers to Treasury Inflation-Protected Securities, which are a type of security issued by the U.S. Government. The General Board uses TIPS in its investment funds to provide participants with a diversified suite of investments and to manage the risk of unexpected inflation. This article will explain the features of TIPS and illustrate how they are an important element of a diversified investment portfolio.

In order to describe TIPS in detail, it is important to understand the concept of inflation and its impact on retirement savings.

Inflation

Economists use the term “inflation” to denote an ongoing rise in the general level of prices. In an environment of rising prices, a dollar buys less each year. Inflation results in a decline in purchasing power. Imagine if, 50 years ago, you had $20,000. That sum would have purchased a home. Today, it is unlikely that $20,000 would be sufficient to make a down payment because purchasing power has declined. Similarly, the cost of postage has greatly increased. You could mail a letter with just a few cents 50 years ago. Now, it costs almost 50 cents to mail a letter. These two examples illustrate the importance of purchasing power. When you look at the money you have, you also need to consider what things cost and what that money will buy.

In the United States, the inflation rate is most commonly measured by the percentage rise in the Consumer Price Index (CPI), which is reported monthly by the Bureau of Labor Statistics (BLS). The CPI is an important number to remember when trying to understand how TIPS work.

Effect of Inflation on Investment Portfolios

Inflation can have a huge effect on investment portfolios. Investors need to consider how inflation can erode the value of each dollar in their portfolios over the years. The erosion can seem slow from year to year. However, because of the compounding effect of inflation over time, failing to account for inflation in a retirement savings plan can be devastating to maintaining one’s lifestyle in retirement.

This is where TIPS come into play.

What are TIPS?

TIPS are U.S. government securities that protect purchasing power with a feature that annually adjusts values for inflation. Other countries offer inflation-adjusted securities, but TIPS refers only to securities that carry the full faith and credit of the U.S. government. In the United States, the value of TIPS increase when the CPI changes. Investors who hold TIPS to maturity receive protection from unexpected increases in the CPI (Inflation).

How do TIPS work? The Break-even Inflation Rate

Break-even inflation is the difference between the effective interest rate earned on a traditional U.S. Treasury security and the yield on a TIP of similar maturity. For traditional U.S. Treasury securities, the U.S. government guarantees a specified rate of interest for the life of the security. The amount of interest is fixed and pre-determined. TIPS pay a lower interest rate, but also have a variable element. Effectively, TIPS pay “bonus” interest equal to the rate of inflation. The break-even inflation rate is what investors collectively expect the rate of inflation will be during the life of the security. Hence, TIPS protect investors from the possibility of unexpected inflation. If inflation is greater than expected, then TIPS provide a better return to the investor than traditional U.S. Treasury securities.

For example, suppose TIPS maturing in five years pay an interest rate of 0.50%, and Treasury notes due in five years yield 2.00%. This implies that the market collectively anticipates that the rate of inflation will average 1.50% annually over the next five years. If actual inflation matches what is expected, then the return from holding the five-year TIPS and the five-year Treasury note until maturity will be the same. If inflation turns out to be higher than 1.50%, then TIPS will provide a greater return compared to the Treasury note. The inverse is true if inflation is lower.

The amount paid for TIPS is indexed to inflation and rises with inflation, as measured by the CPI for All Urban Consumers. Each month, the U.S. Treasury Department applies the difference between the latest CPI number and the previous CPI number to adjust the value of TIPS with a two-month time lag. So if the CPI increases by 0.3% in November, the Treasury Department will increase the principal value of every TIPS bond by 0.3% in January.

The Treasury Department has a mechanism in place to track inflation on every TIPS security from the time of issue until the time it matures. The principal values and interest payments for TIPS are calculated using the index ratio—the change in the CPI from security issue date to the current date. In times of inflation, TIPS principal value and interest payments increase. In times of deflation, principal and interest values decrease. However, the principal value of TIPS never adjusts lower than the original face value, which is an important safeguard for investors.

Disadvantages of TIPS

It is important to note that the expected inflation rate plays a big part in determining if TIPS are a better investment option than traditional U.S. Treasury securities. An allocation to TIPS in an investment portfolio during deflationary periods can be a less rewarding investment when compared to an investment in traditional U.S. Treasury securities. However, since no one has a crystal ball to predict the future, TIPS are an important element to include in a diversified portfolio as they can weather a range of economic climates.

It is also important to note that inflation-protected securities contain an additional cost when compared to nominal bonds—inflation risk premium. In much the same way as an insurance policy holder must pay to insure assets, the inflation risk premium is the cost a holder of an inflation-protected asset must pay. When purchasing a traditional U.S. Treasury security, the holder of the security bears the risk for inflation. For TIPS, the U.S. government bears the risk for inflation. The inflation risk premium is the cost an investor incurs for passing the risk of inflation off to the government.

The General Board Solution

The General Board’s Inflation Protection Fund (IPF) consists primarily of U.S. and international government-issued inflation-protected securities. The fund is designed to help protect investors from unexpected inflation. The fund addresses the cost of the inflation risk premium by including additional investments, such as commodities, which have historically provided protection against inflation.

Including the IPF as part of a diversified investment strategy supports the General Board’s objective of providing participants with the opportunity to build an exceptionally well-diversified portfolio. You can read more about the Inflation Protection Fund here. For a detailed description of IPF, see the Investment Funds Description.