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How to Hedge Against Inflation - "TIPS"

| January 31, 2018
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Prices are rising faster for items that are common to our aging population than they are for all items in general – such as health care, food, and transportation. Also, prices are rising faster for those who live in California, particularly the Bay Area, than they are for the nation in general.  Individuals living on a mostly fixed level of income must deal with the risk of rising prices outpacing their income growth. The impact of Inflation outpacing their income may not be noticeable within each year, but the consistent erosion of purchasing power in the long-term can have dramatic effects on the standard of living for future retirees. Even with the annual cost of living adjustments to fixed income payments such as social security or private and public pensions, the adjustment, because of it’s age and location limitations, often does not fully reflect the actual price growth of items particular to any individual.

The U.S. and other global economies are experiencing rapid growth, tax reform will lower corporate taxes; unemployment is at a historical low, and interest rates, although expected to increase this year, remain relatively low. Following economic theory, all these factors should place pressure on wages and prices of consumer goods – inflation.

Fixed income investments are needed in a portfolio to provide stable income and provide the powerful effects of diversification with other portfolio investments. The returns on fixed income investments will depend on the term of the bond (maturity) and the credit quality. The trade-off with fixed income investments, such as bonds, is choosing longer-term bonds that may provide higher yields than shorter-term bonds - but the longer the term for a bond, the greater the risk of returns not keeping up with pesky inflation.

The ideal solution would be an investment whose returns match longer-term bonds and are adjusted annually for inflation, as reported by the Consumer Price Index. That’s a lot to ask for when it comes to basic fixed-income investments that simply pay interest every six months. But there is an investment that is offered by the U.S. Treasury, called “Treasury Inflation Protected Securities (TIPS),” which are adjusted semi-annually, like an adjustable loan. But in this case, you are the lender, and it is you who will receive the higher payments. But as far as matching longer-term returns; it depends on one factor – actual inflation.

Inflation-protected securities (TIPS) are securities whose principal and interest payments are adjusted for inflation, unlike conventional debt securities that make fixed principal and interest payments. A TIPS is a bond sold at auction that receives a fixed stated real rate of return but also increases its principal according to the changes in inflation, as measured by the non-seasonally adjusted U.S. Consumer Price Index for All Urban Consumers (CPI-U).

TIPS guarantee a real rate of return – The real rate of return is a return adjusted for inflation -  or simply called an “inflation-adjusted return.” For instance, if the rate of inflation cited for 2017 is 2.0%, and you earned a gross 5% on an investment, you earned a 3% real return (5% gross/nominal return less inflation rate of 2%). Since TIPS are fixed-income bonds, the real return is calculated by subtracting inflation from the gross return of a government bond with a similar maturity as an inflation-protected bond, such as the U.S. Gov’t 10-year bond.

 The major benefits of TIPS are:

  • They insulate investors from the risks of unexpected inflation.
  • They have no credit risk (U.S. Gov’t issued).
  • They are generally less volatile than nominal return bonds of similar maturity.
  • They have lower correlations to equities than nominal return bonds, making them more effective diversifier of equity risk.

 

How Do TIPS Work?

For example, if a $1,000 TIPS had a stated real interest rate of 3 percent and the CPI-U rose 2 percent during the year, the math would work as follows: First, the adjustment to principal is calculated. Thus, the principal would rise from $1,000 to $1,020, an increase of 2 percent (inflation rate). Second, the interest payment would be calculated from the new principal. With a real rate of 3 percent, based on the principal of $1,020, the amount of interest would be $30.60. This increase gives an investor protection against inflation by providing a guaranteed real return over a predetermined investment horizon. Interest is paid (the real rate) and accrued (the inflation adjustment) semiannually. At maturity, the bondholder receives the greater of the inflation-adjusted value or par. 

The potential downside of TIPS is that the expected inflation doesn’t happen! Then the real rate of return will remain below what could have been received by a comparable nominal return bond (10 yr). Also, if interest rates rise without accompanying inflation, the value of the TIPS will fall (only material if you plan on selling TIPS before maturity).

 

¹Consumer Price Index For All Urban Consumers/U.S. Bureau of Labor Statistics

Alternative Protection against Inflation

 During periods of inflation, the prices of tangible assets such as real estate, or commodities, have historically increased (which makes sense) along with more common expenditures. A well diversified investment portfolio will hedge itself against unexpected inflation by including real estate funds (REIT’s), or commodities (mutual fund), and inflation-protected bonds (TIPS).

Carr Wealth Management, LLC can help you by answering any questions you may have about Inflation-Protected Securities or other services we provide to help people gain access to a more efficient way to invest. Please contact us for a no-charge consultation.

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

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