Retirement Savers: Consider Using TIPS to Hedge Against Inflation

To help curb record-setting inflation, the Federal Reserve Bank enacted its second consecutive 0.75-percentage-point increase to the Fed Funds rate on July 28. Despite the Fed's aggressive moves, significant uncertainty remains. Financial analysts are unsure whether the rate increases will work—or where the stock and real estate markets are headed.

Clearly, this isn't an ideal situation for retirement savers, especially those nearing that goal line. You might be thinking about investing a portion of your nest egg conservatively and in a way that also offers some safeguards against inflation. Here's an option to consider.   

What Are TIPS?

U.S. Treasury Inflation Protected Securities (TIPS) are a special variety of Treasury bonds that are adjusted for inflation. Specifically, in times of inflation, TIPS principal balances are adjusted upward twice a year, based on changes in the Consumer Price Index, so inflation doesn't hurt as much. In contrast, significant inflation can punish the standard conservative investment strategy of buying regular U.S. Treasury notes or bonds.

How Do These Securities Work? 

TIPS are sold at original issuance with terms to maturity of 5, 10 and 30 years. They pay cash interest twice a year at a fixed rate, set at issuance. And the principal balances of TIPS will be adjusted upward twice a year, during inflationary times.

You receive the following two types of returns if you hold a TIPS bond to maturity:

• Biannual interest payments at the stated fixed annual rate. Each payment equals half the stated annual rate times the inflation-adjusted principal balance at the time of the payment. So, interest payments go up with inflation because they're based on the increasing inflation-adjusted principal balance.
• The inflation-adjusted principal balance at maturity, which has been increased by the inflation that was measured during your holding period.

Here's a simple example. Suppose you invest $200,000 in an original issue five-year TIPS bond with a face value of $200,000 that pays a fixed annual interest rate of 0.5%. If inflation over the next six months is 7%, the inflation-adjusted principal balance is increased to $207,000 ($200,000 times 1.035), and you'll receive an interest payment for that six-month period of $518 ($207,000 times 0.5% times ½).

If the inflation rate for the following six months is 6%, the inflation-adjusted principal balance is increased to $213,210 ($207,000 times 1.03), and you'll receive an interest payment for that six-month period of $533 ($213,210 times 0.5% times ½).

If inflation then runs at exactly 4% for every six-month period for the following four years, your interest payments will increase based on the inflation-adjusted principal balance for each six-month period. You'll receive $249,809 at maturity ($213,210 times 1.02 to the eighth power). 

How Much Do TIPS Cost?

As of this writing, TIPS bonds maturing on July 15, 2027, that pay a fixed annual interest rate of 0.375%, were trading in the secondary market at 100.7—and the inflation-adjusted principal balance factor for these bonds was 1192 (per $1,000 of face value). That means the price for one of these bonds with a par value of $100,000 was $120,034 ($100,700 times 1.192). The nominal annual yield, which ignores inflation, on this bond was 0.238%.

If there's no further inflation, you would collect a total of about $121,435 from your $120,034 investment. This is comprised of the $119,200 inflation adjusted principal balance at maturity plus interest totaling about $2,235 ($119,200 times 0.375% times 5 years).

If there's significant inflation, the twice-yearly interest payments will increase as the inflation-adjusted principal balance goes up. But the interest payments still won't amount to much because the fixed annual rate is so low (0.375%).

During those high inflation times, the real money is earned from the fact that the principal balance will be adjusted for inflation. If you hold the bond to maturity, you'll collect the biannual inflation adjusted interest payments plus the inflation-adjusted principal balance as of July 15, 2027. If you sell before maturity in the secondary market, there are no guarantees on what you'll get.     

What's the Return on a TIPS Bond?

Let's suppose you paid $120,000 in the secondary market to buy a TIPS bond on July 15, 2022, with a face value of $100,000, an inflation-adjusted principal factor of 1.192 and a fixed annual interest rate of 0.375%. The bond matures on July 15, 2027.

If you hold the TIPS bond to maturity and inflation runs at about 5% during your ownership period, you'll recover your $120,000 investment plus about 5.375% annual interest (the fixed 0.375% annual rate plus 5% for inflation). As of this writing, the nominal yield (ignoring inflation) on a regular $100,000 10-year Treasury bond bought in the secondary market and held to maturity was about 2.78%. The nominal yield on a two-year Treasury Bond bought in the secondary market and held to maturity was about 3.04%.

In rough numbers, you would need annual inflation to exceed about 2.405% (2.78% minus 0.375%) for your TIPS investment to beat the 2.78% yield on the regular 10-year Treasury bond.

If inflation averages about 5% during your five-year ownership period for the TIPS bond maturing on July 15, 2027, you'd come out well ahead. At the end of the day, you'd collect $155,900 from your $120,000 investment based on an annual return of 5.375% for five years. (Note that this calculation ignores the relatively trivial inflation increases to the semi-annual interest payments, which will give you a little extra money over your ownership period.) Obviously, 5.375% is better than 2.78%. But the 2.78% is a sure thing if you hold the regular bond to maturity while the 5.375% on the TIPS bond is just an educated guess.        

In summary, TIPS have a clear advantage over regular Treasury instruments if there's significant and persistent inflation.

What Happens If There's Deflation?

During periods of deflation, TIPS principal balances are adjusted downward twice a year. The biannual interest payments are also adjusted downward because they're based on a declining adjusted principal balance. The stated fixed interest rate itself doesn't change. 

However, even in the worst-case scenario of significant deflation during your ownership period, the results from owning a TIPS bond won't be catastrophically bad, as long as you hold the bond to maturity. That's because you're guaranteed to receive at least the face value of the bond at maturity, even if the adjusted principal balance has fallen below that number. If the inflation-adjusted principal balance exceeds the face value, you'll receive the larger inflation-adjusted number.

So, if you bought a TIPS bond that matures on July 15, 2027, for $120,000, you'd collect at least $100,000 when it reaches maturity—even if there's significant deflation during your ownership period. However, this certainly isn't a good result, because you paid $120,000 for the bond and earned only minimal interest while you owned it.  

Where Do You Buy TIPS?

The minimum face value for a TIPS bond is $1,000. Larger denominations are available in $1,000 increments. You can purchase TIPS upon original issue directly from the government through the online Treasury Direct program . If you buy a newly issued TIPS bond via Treasury Direct, you'll receive at least the face value of the bond if you hold it to maturity, even if there's significant deflation. This option is only available for TIPS purchased for taxable accounts. You can't use a tax-favored retirement account, such as an IRA, to buy TIPS upon original issue via Treasury Direct.

TIPS are marketable securities, so you can buy previously issued TIPS bonds in the secondary market through your brokerage firm. You can use a tax-advantaged retirement account or a taxable brokerage firm account to buy TIPS in the secondary market.

If you buy older TIPS in the secondary market and pay for the inflation adjustment to the principal balance, that adjustment can vaporize with deflation. The way to avoid this risk is to buy TIPS when they're issued or shortly thereafter. That way the inflation adjustment to the principal balance will be little or nothing, and there will be less to lose in the event of deflation. Of course, if you pay a premium to buy a TIPS bond, you can potentially lose that, too.

Beware: As with other Treasury instruments, secondary market prices for TIPS bonds fluctuate due to changes in prevailing interest rates and supply and demand. Other things being equal, the secondary market price of TIPS will go down when the yield on regular Treasuries goes up, because that reduces the inflation protection advantage of TIPS. On the other hand, other things being equal, the secondary market price of TIPS will go up when the yield on regular Treasuries goes down, because that increases the inflation protection advantage of TIPS. If you don't intend to hold your TIPS to maturity, understand that market prices can and do change on a daily basis. And there's no certainty about how much you can sell your TIPS for in the secondary market.

What Are TIPS ETFs?

A simpler alternative to direct ownership of TIPS is buying shares in an exchange traded fund (ETF) that invests in a basket of TIPS bonds that simulate the results from direct investments in TIPS. You can hold TIPS ETFs in a tax-advantaged retirement account or in a taxable brokerage firm account. TIPS ETFs usually pay monthly distributions. However, distributions may be skipped in times of deflation.

The total return from holding a TIPS ETF depends on the distributions that you receive (usually monthly) and the appreciation or depreciation of the share price. As investors have discovered this year, share prices can go down or up depending on bond market changes. Significant downward moves have occurred this year. In general, share prices of ETFs that hold longer-term TIPS are more volatile than those that hold shorter-term TIPS. Contact your SSB advisor for more information about TIPS ETFs.    

Tax Considerations for TIPS

When you hold a direct TIPS investment in a taxable brokerage firm account, the cash interest payments and any positive inflation adjustments to the principal balance will be high-taxed ordinary income for federal tax purposes—even though the inflation adjustments aren't currently paid in cash.

Important: The good news is that state income taxes aren't owed on TIPS cash interest payments or inflation adjustments.

Paying current taxes on the inflation adjustments isn't good, because you won't actually collect them until the TIPS matures or you sell it in the secondary market. In other words, you have to pay taxes on "phantom income."

You can avoid that problem by holding direct TIPS investments acquired in the secondary market in a tax-advantaged retirement account, such as a traditional or Roth IRA, 401(k) or SEP.

If deflation occurs, the principal balance of a TIPS bond is adjusted downward, which will lower the cash interest payments. For federal tax purposes, a negative principal balance adjustment reduces taxable interest income from future cash interest payments.

When you hold a TIPS ETF in a taxable account, the distributions that you receive (usually monthly) are generally high-taxed ordinary income for federal tax purposes. However, some distributions may include lower-taxed long-term capital gains. If you sell a TIPS ETF for a gain or loss, it's a short-term or long-term capital gain or loss, depending on how long you held the shares.

A key takeaway is that taxes are irrelevant for TIPS that are held in a tax-favored retirement account. The money that you make or lose will simply affect the retirement account balance, and the amount that you'll eventually be taxed on when you take withdrawals. Of course, qualified Roth IRA withdrawals are currently free from federal income tax.

Are TIPS Right for You?

Investing in original issue TIPS instead of "safe" garden variety fixed income instruments will pay off if there's significant inflation and you hold them to maturity. The same is true in an inflationary environment for TIPS purchased in the secondary market and held to maturity. If you sell sooner, you're subject to the whims of the Treasury bond market and results can vary. For instance, the price of TIPS can drop if yields on regular Treasuries go up. 

If you buy a TIPS ETF, you're also subject to the whims of the Treasury bond market. So far this year, the results from holding TIPS ETFs haven't been good.

In the current investment environment, there are no sure things. And TIPS are no exception, despite raging inflation. Contact your SSB advisor to help evaluate your options.