Treasury Inflation Protected Securities (TIPS)
Deflation is a condition in which there is a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation has often had the side effect of increasing unemployment in the economy, since the process often leads to a lower level of demand in the economy. This week’s column is about Treasury In-flation-Protected Securities, or TIPS for short.
Well, Randy, which is it—inflation or deflation? Unlike the talking heads on television that do "know," I don’t. But there is an old saying in the investment business that makes sense, "Buy snow shovels in the summer and straw hats in the winter." I like that saying because I’m one of the few who still wears straw hats.
TIPS are government guaranteed bonds, first issued in January 1997, that promise to keep your return up with the Consumer Price Index (CPI). Who’s worried about inflation with the talk when the big question about next week’s Federal Reserve meeting is, "Will they cut the Fed Funds rate (the interest rate at which U.S. banks lend to one another their excess reserves held on deposit at the U.S. Federal Re-serve) by 1/4 of 1/2% next week?" Either way, a cut will bring rates down to near 0, where they were in the 1940’s!
I am worried because I went to East Germany last week to referee my 31st World title-boxing match and I paid $1.30 for Eurodollars. They used to be 80 cents! A decline in the value of the dollar generally adds inflationary pressure in the form of higher import prices, especially for oil. Finally, a return to Federal government deficits, rather than the surpluses of the past few years, could raise interest rates and lead to higher overall price levels.
This higher inflation scenario may be less than a 50-50 possibility, but having a few TIPS in your portfolio isn’t necessarily a bad idea. Here’s how they work. Like most bonds, Treasuries or otherwise, TIPS pay a fixed rate of interest. So, how do they provide inflation protection? By changing the principal value of the bond.
Every six months, the principal value is adjusted based on the inflation rate during that period measured by the Consumer Price Index for All Urban Consumers (CPI-U). For example, if inflation were to hit 2% over a sixmonth period, a TIP bond’s capital val-ue would increase from $1,000 to $1,020.
As luck would have it, the gain in the face value is taxable in the year in which it is accrued, as is the interest, at the Federal level. However, TIP interest is free from state and local taxes. The interest rate of the bond would then be applied to the increased principal. If the bond’s interest rate were 5%, the interest payment would go from $25 (for six months) to $25.50. Ad-mittedly, this doesn’t seem like much, but accumulated over time, it can add up.
How big is the TIPS market? Eco-nomists forecast that the Treasury will sell more than $20 billion in TIPS this year and $30 billion next year. In July, the Treasury will switch to a new schedule of four TIPS auctions a year. It will sell new 10-year notes in July and January, with reopenings in Octo-ber and April. When you add the new sales to the existing market which, at around $180 billion, is comparable in size to the European corporate or global high-yield, or junk bond sectors—"it ain’t hay."
Although many economists doubt the U.S. faces a significant threat of deflation, TIPS may provide a hedge against that and inflation. The Treasury guarantees a deflation-protected principal for TIPS, meaning they will re-turn face value even if interest rates fall steadily.
There are a variety of ways to purchase TIP securities. You can buy them through a typical brokerage account, just as you would other securities. They’re also available through Treasu-ryDirect, the Treasury’s very efficient and easy to use Internet site (www.-treasurydirect.Rov). Finally, several mutual funds invest in TIPS, including funds offered by Vanguard, American Century, and PIMCO.