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Submitted by: Paul Palmer
Paul Palmer is the Managing Partner of Cypress Advisory Services, Ltd, LLP, a comprehensive wealth management firm in Houston, Texas. Paul is a 23 year veteran of the financial services industry. Both he and his partner, Kurt Box are CERTIFIED FINANCIAL PLANNERŪ practitioners. The firm's comprehensive approach and unique institutional money management style give its clients peace of mind along with cutting edge financial advice.
To quote a Morningstar article from March 2001, “While fast-paced technology high flyers were the subject of some of investors’ favorite “hot” tips going into last year, investors who chased them saw stock values plummet. Meanwhile, the forces that contributed to the ripping of the valuation balloon gave unusual success to another kind of TIP - the boring Treasury bond with the inflation guarantee. Treasury Inflation-Protected Securities, or TIPS, rode the sharp fall in real rates (interest rates minus inflation) that came about last year as interest rates dropped sharply while inflation held steady, and finished the year with about a 13% gain. With stocks declining and the economy slowing sharply, many investors are focusing on portfolio diversification options that would soften the blow from further declines in equities.”
Unfortunately, very few investors read this article and it is likely that far fewer followed its salient advice. While conditions are certainly different today (bubbles exist in other areas of the world stock market) it is our opinion that Treasury Inflation Protected Securities (“TIPS”) remain a very effective diversification tool.
What Are TIPS?
TIPS are patterned after Real Return Bonds issued by the Canadian government (inflation-protected bonds have been offered in other countries for more than 20 years). The United States Treasury launched the first TIPS in 1997 as a vehicle to provide investors with insurance against inflation. By holding the bond to maturity, an investor has a guarantee that their purchasing power will not be diminished. This is a key tenet of investing.
The structure of a TIP is straightforward. The interest rate is set at auction (i.e. the initial sale of the bond to public by the US Treasury), and remains fixed throughout the term of the bond. The principal portion is adjusted for inflation, and is paid at maturity. Interest is paid semiannually, and adjusts upward for inflation as well, since it is based on the inflation-adjusted principal value. Inflation is pegged to the Consumer Price Index for All Urban Consumers (CPI-U, which is the one you see commonly quoted, often as just CPI). TIPS are currently issued in 5, 10 and 20-year maturities. At maturity, the principal value paid will be at least the face amount, so investors would get an extra boost in purchasing power in the unlikely event of deflation (deflation is an overall decline in the price of goods and services typically occurs during recessions).
.jpg) In Example #1 above, an investor buys a $1,000 US Treasury Inflation Protected bond. At the time of the purchase the inflation rate (i.e. CPI) is 3.0% and the bond pays a 3.4% coupon (thus the nominal rate is 3.0% + 3.4% = 6.4%). The example assumes inflation remains steady at 3.0% AND real interest rates do not change over the life of the bond. In Example #2, the same assumptions apply except the inflation rate is 5.0% and the bond pays a 3.4% coupon. Notice how the coupon is slightly higher each year when compared to example #1 as the coupon for each ½ year is: 3.4% x Adjusted Principle x ½. The Adjusted Principle is being adjusted upward each year by 5% in Example #2 compared to only 3% in Example #1. However, the Taxable Amount is much higher as the Taxable Amount is the Coupon Payment plus the change in the Adjusted Principle. In Example #2 you receive less after tax each year, but your return is higher due to the much higher lump sum payout in year 5. These examples also demonstrate why these investments are best held in tax deferred accounts. In a high inflation environment your tax might actually exceed the coupon payment. Of course, at that point your conventional stocks and bonds would likely be losing significant value so you would be very happy to own the TIPS!
In the real world, however, real interest rates do change and investors buy and sell bonds everyday, they do not wait until the bond matures. In terms of what impacts TIPS returns, think of them exactly as you would a regular bond, except that the old familiar inverse relationship between yield and price has an extra wrinkle. A regular bond needs to decline in value when nominal interest rates (which is the real rate plus inflation) rise so that its yield to a purchaser is effectively “reset” to the current market rate (and vice versa when rates fall). For example, if you purchased a 5 year $1,000 regular savings bond last year and it is paying you $70 (or 7%) annually and today the bank will issue you a 4 year savings bond that will pay you only $40 (or 4%), would you sell your 7% coupon savings bond to somebody for $1,000? Of course not; you would demand the price that it would take for you to go to the bank and buy savings bonds that would pay you your $70. Incidentally, the figure you would require is $1,750 which is: $1,000 + $1,000 * ((.07 - .04) / .04). A TIPS’ value, however, moves in relation to real rates. Real rates are a function of two things - inflation and interest rates - so there are more permutations possible. But the bottom line is the same: when real rates fall, the price of a TIP moves higher, effectively “resetting” real return for a purchaser to the new, lower market rate. If real rates rise, the value of the TIP will fall. So the return from TIPS will be a function of its coupon, inflation, and price changes to the underlying bond that occur along the way as real rates change.
Portfolio Benefits
TIPS are a simple way to achieve perhaps the most fundamental goal of investing: preservation/growth of purchasing power. Held to maturity, they are virtually risk less. Taken as a distinct asset class and used as a component of a broader portfolio, TIPS are one of the only asset classes that respond positively to inflation - almost all other asset classes respond negatively to inflation (save for commodities). The ultimate for a TIPs investor (and this occurred in the year 2000) is for rising inflation and falling real interest rates. In fact, this is often the scenario just before and during an economic slowdown or recession.
Summary
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TIPS prices rise and fall like bonds, but in response to changes in real, rather than nominal, interest rates.
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TIPS have low correlations to other financial assets and respond favorably to the kind of high-inflation environment that would hurt both stocks and conventional bonds. As such, they have value as a portfolio diversifier.
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Tax liabilities can exceed coupon payments and erode returns in an environment of rising inflation, making them better suited for tax-deferred accounts.
Paul Palmer, Jr. and Kurt L. Box are Investment Advisor Representatives with Cypress Advisory Services, Ltd., LLP, a Securities and Exchange Commission (SEC) Registered Investment Advisor.
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