By Ben Mattlin
December 2, 2024
https://www.fa-mag.com/news/inflation-is-up–is-it-time-for-tips-80513.html?section=110
In late November, the Personal Consumption Expenditures (PCE) index—the Federal Reserve’s preferred inflation gauge—jumped 2.3% from a year earlier. That two percentage point increase was enough to fuel fears that inflation might be climbing again.
Many of those who are concerned about inflation are snatching up Treasury inflation-protected securities (TIPS), experts say. These U.S. bonds are designed to safeguard investors against losing purchasing power in later years. But are they a wise choice right now?
“TIPS work best in protecting investors from unexpected inflation,” said Dan Newhall, head of portfolio solutions in Vanguard’s financial advisor services group in Malvern, Pa. “Or, in other terms, inflation surprises.”
At the moment, he said, the market has already priced in a greater likelihood of increased inflation, partly because of the incoming Trump administration’s promised tariffs, tax cuts and immigration crackdown. What’s less certain, however, is the magnitude of price increases, he said. If inflation exceeds market expectations, TIPS would benefit investors. But if the market has overestimated inflation, other securities, such as standard Treasurys, would prove better because their yields lock in current market expectations, he said.
TIPS are Treasury bonds that are linked to the Consumer Price Index (CPI), a separate measure of inflation. Their principal value rises or falls with changes in the CPI. They pay a fixed rate of interest every six months, but the actual payment amounts vary as the bond’s principal value changes. TIPS come in maturities of five, 10 or 30 years. At maturity, the bondholder will never receive less than the original invested amount, even if the CPI is down.
At present, the real yields on TIPS—their payouts after inflation—are near 2% or higher, which market watchers say is better than their historical average. Though traditional Treasurys invariably have higher yields, their principal values might not keep pace with inflation. TIPS’ underlying values will.
“Investors usually have to pay a heavy premium for a guaranteed real return plus inflation security,” said Eric Lutton, co-CIO at Sound Income Strategies in Fort Lauderdale, Fla. That’s why TIPS might be paying 2% plus inflation while the equivalent standard Treasury bond pays about 5%, he said.
If inflation amounts to 2.5%, say, TIPS with a 2% coupon will effectively pay out 4.5%, underperforming traditional Treasurys that have a 5% return. But if inflation goes above 3%, the TIPS would outstrip the equivalent regular Treasurys, he said.
Therefore, if inflation doesn’t turn out to be “materially higher” than what the Treasury market expects, he said, “TIPS will usually underperform normal Treasury bonds.”
But no one can accurately predict how markets or inflation might move. Some advisors point out a number of reasons why inflation might actually decrease in coming years.
For instance, Dustin Thackeray, CIO at Crewe Advisors in Salt Lake City, cited possible technological improvements related to artificial intelligence; likely reductions in government spending, perhaps generated by the proposed Department of Government Efficiency; and even a slowdown in the Fed’s interest-rate cuts as factors that could prove deflationary.
“Some investors learned a hard lesson in 2022, as the Federal Reserve began to hike interest rates to combat inflation [and] TIPS with any level of extended duration saw subsequent principal value declines,” he said.
TIPS Funds and ETFs
If TIPS are right for a client, the next consideration is whether to buy them individually or as a group in a mutual fund or exchange traded fund.
Some advisors say that buying individual TIPS directly from TreasuryDirect.gov has several advantages. Clients can choose between five-, 10- and 30-year terms, and invest anywhere from $100 to $10 million (or up to 35% of the offered amount in a competitive bid at a Treasury auction or in the secondary market through a broker). There are no annual management fees that can eat into returns over the long run, unlike funds. And if clients hold the TIPS all the way to maturity, their return of principal is guaranteed—a certainty that TIPS funds cannot provide.
Buying individual TIPS also allows clients to build a TIPS ladder with different maturities, said Thackeray, which “may make sense as a way to diversify the timing of the investment.”
A TIPS fund or ETF is generally a more convenient path to diversification, he said. TIPS funds can be “broadly diversified and hold a variety of maturities, which may provide broader exposure than individual TIPS,” he said.
TIPS funds and ETFs generally have a monthly payout, whereas individual TIPS only generate income twice a year. The funds also provide greater liquidity, which individual TIPS don’t, advisors say. You can buy and sell them whenever the market is open. That means, however, that TIPS funds are subject to market fluctuations, say advisors, so repayment of the original face value is not guaranteed.
Yet another key consideration involves taxes. “The IRS considers the change in value from the CPI adjustment to be taxable income. However, [with an individual TIPS] the investor does not receive this amount until the bond matures,” said Karen Veraa-Perry, head of U.S. iShares fixed income strategy for BlackRock in San Francisco. “This lack of cash flow to pay the tax bill is known as phantom income.”
TIPS ETFs, though, typically pay out the CPI adjustment “as part of the monthly income, which solves the phantom income problem,” she said.
To be sure, there are other types of inflation-protection bonds. For example, some clients may be tempted by Series I Savings Bonds, also known as “I Bonds.” They earn income through a fixed rate that doesn’t change throughout the life of the bond plus a variable rate that’s adjusted up or down every six months with changes in the CPI. Earnings are typically exempt from state and local taxes and, if the proceeds are used for qualified education expenses, the interest is also usually exempt from federal income taxes.
I Bonds can be purchased for as little as $50 from TreasuryDirect.gov (they cannot be bought or sold on the secondary market), up to $10,000 per Social Security number per year. They have an initial maturity of 20 years, which can be extended to 30 years. They must be held for at least one year, and if redeemed in the first five years, the bondholder forfeits three months of accrued interest.
Despite these restrictions, I Bonds seem to promise a higher return than TIPS, said Vanguard’s Newhall. As of the end of November 2024, their rate was 3.11%, roughly two points higher than TIPS. But that can be deceptive, he said. The I Bonds rate is not guaranteed for the life of the bond. It resets every six months. Factoring in their lack of liquidity and relatively meager maximum investment, “there’s really no comparison,” he said.
Whichever way the CPI moves in the coming months, some advisors say that allocating a portion of a client’s bond portfolio to TIPS is always a good idea for long-term planning. They are “not just for when inflation fears are on the rise,” said Daniel Shomper at Fairway Wealth Management in Independence, Ohio.
Sudden changes in the CPI won’t change that, he said. TIPS are designed to protect purchasing power “over longer periods of time,” he said.
