Investors often include bonds into their portfolios to earn income and take less risk than investments in stocks and other growth asset classes. Bonds that pay a set rate of interest carry a unique risk in their own right – the risk that those interest payments do not keep pace with a rising cost living.
The Good News
There is good news for bond investors. Starting in 1997 the U.S. Treasury has issued a type of bond with characteristics that may protect against unexpected spikes in the cost of living. These investments, known as Treasury Inflation Protected Securities (TIPS), provide interest payments like traditional bonds, but also provide inflation adjusted increases in both the principal value of the bonds and the regular interest payments.
This mechanic means that it takes an extra step to figure out the rate of return investors may earn on the investment. In a traditional bond, investors will look at their yield to maturity to calculate the rate of return they may earn when the bond matures in full. With TIPS, investors have two components to their return, the yield to maturity on the bond, plus an unknown – the rate of inflation between now and the maturity date.
The unknown variable, the rate of inflation, may sound like it is adding an element of risk. In fact, it is taking one form of risk off the table for the bond investor, the risk that inflation exceeds its rate of return.
How it Works
How does an investor evaluate TIPS for inclusion in a bond portfolio? One approach is to compare yields. Let’s say that a traditional bond carries a yield to maturity of 3% for five years, and a comparable TIPS bond carries a yield to maturity of 1% plus inflation adjustments. That would mean that if inflation is precisely 2% per year between today and the bond’s maturity in five years, investors will have earned the same rate of return on both bonds. Investors in TIPS would benefit from higher inflation, earning 4% in this example if inflation rises to 3%, but would earn lower returns if inflation falls to 1%.
In 2018 TIPS present an interesting opportunity for bond investors. Based on yield differentials as of September 2018, the rate of inflation would need to be about 2% for investors to earn the same rate of return in TIPS as they would in traditional bonds. 2% is about the rate of inflation that the U.S. has experienced on average since the 1990s, but there is a chance that this rate may increase in the future. Reasons to worry about an increase in the cost of living include: 1) a very low unemployment rate, below 4% as of 2018 2) trade tariffs may increase the cost of imports and 3) tax legislation passed in 2017 adds fiscal stimulus as an inflationary driver. If these factors push inflation higher than 2% in the coming years, TIPS investors may benefit.
TIPS bonds carry the unique characteristic of an inflation adjustment. This allows investors the potential to protect a portion of their bond portfolios against the risk of unexpected increases in inflation. We believe that today’s valuations on TIPS and the potential for rising inflationary pressures make them an investment worthy of consideration today.
Important disclosure information
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