Although US GDP and the unemployment rate have recovered remarkably quickly, this progress has come with the cost of higher inflation, which rose to 6.2% in October. The causes of this inflation spike are likely multifaceted, including supply chain blockages, changes in consumer behavior (buying more goods instead of services with COVID still a threat), and large spending packages from the late Trump and early Biden administrations. To some extent, as Fed Chair Jerome Powell has stated, the inflation increase may be transitory. But even if the inflation rate declines, we know neither how quickly it will fall, nor where it will eventually settle. In the interim, it is worth exploring ways to protect a portfolio from inflation; we’ll begin today by discussing Treasury Inflation-Protected Securities (TIPS).
TIPS are bonds issued by the US government with built-in inflation protection. Just as you can buy a 10-year US Treasury bond, you can also buy a 10-year US TIPS. A Treasury Inflation-Protected Security is a bond whose principal value is adjusted for inflation, as measured by the Consumer Price Index. So, if you own $1,000 in US TIPS, with a coupon rate of 0.50%, you would receive $5 in coupon payments if there is no CPI inflation that year. If inflation rose 5% that year, however, the principal would be adjusted to be $1,050, and your coupon payment would increase to $5.25. If deflation occurred, your principal value and coupon payments would fall; however, when the bond matures, you can never receive less than your original principal amount, so there is long-term deflation protection.
How do TIPS compare to regular US Treasury bonds? As you might expect, if you’re buying inflation protection, you should expect to receive lower interest rates in return. Conversely, if you’re buying bonds that are vulnerable to inflation, you would expect to be compensated with a higher interest rate in return—in March 2019 the gap between the 10-year US Treasury and the 1-year US TIPS was 1.75%, which is close to the average inflation rate over the previous few years.
Like all bonds, TIPS face interest rate risk; if interest rates rise, currently owned bonds become less valuable relative to newly issued ones. If interest rates rise as a reaction to inflation, though, then TIPS will likely fare better than conventional bonds.
TIPS can be purchased directly from the US government, or indirectly via ETFs or mutual funds, which may include a TIPS component as an inflation guard. However acquired, TIPS are a straightforward method to buttress a portfolio against unexpectedly persistent or rising inflation.
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This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument or investment strategy. This material has been prepared for informational purposes only, and is not intended to be or interpreted as a recommendation. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice.