Even though we haven’t seen any obvious signs of inflation working through our economy, we are starting to prepare our client portfolios for what seems like the inevitable.  With all the new government programs and national debt, the decline in the dollar, new regulation, and higher taxes on consumer products, we expect inflation to become a problem in the years ahead.

Over the long-term, inflation can be devastating to a financial plan.  Every dollar that you have saved and invested will buy less goods and services in the future.  This loss of purchasing power can be the greatest financial risk to someone living on a fixed income.

So, what can you do to mitigate the risk?  The most common way in the past has been to own hard assets.  That’s why you hear all the talk about buying gold right now.  And that’s one of the reasons that over the last year we have been increasing our exposure to commodities in our client accounts.  Using an exchange-traded index fund, we have been able to get access to energy, agriculture and metals…assets that typically rise in a period of inflation.

Now we are adding another “inflation hedge” to the mix.  As part of our allocation to fixed-income, we are adding some TIPS to our portfolios.  In case you are unfamiliar with them, TIPS are Treasury Inflation Protected Securities.  They are probably the safest inflation hedge available because, like other Treasury securities, they are backed by the full faith and credit of the US Government.

They are similar to other government bonds in that they are issued with a fixed interest rate and maturity date.  And they pay interest twice a year.
So what is different about TIPS?  Unlike other fixed-income investments, TIPS provide protection against inflation.  Your principal in a TIPS increases in periods of inflation and decreases in periods of deflation, as measured by the Consumer Price Index.  Here’s an example of how they work:

Let’s assume that you buy $20,000 of TIPS that pay a fixed rate of 2.5%.  In six months, your first interest payment will be $250. Let’s also assume that in that six month period, the CPI rises at an annual rate of 3%.  Your $20,000 principal would be increased by 1.5%, which is half of the annual rate.  At the end of the next six months, your 2.5% interest payment will be based on the new principal amount, or $20,300.  The new payment will be $253.75.  At that time, your principal will be adjusted again based on the latest CPI numbers.  And so it goes, until the maturity date.

You can buy TIPS individually.  They are sold in increments of $100 and with maturities of 5, 10 or 20 years.  And, because of the guarantee that your purchasing power will not be reduced, they will pay a slightly lower interest rate than an equivalent Treasury security.  You can also get them in a mutual fund or an exchange-traded fund, which is how we are adding them for our clients.

There are a few other things you should know about TIPS.  When a TIPS matures, you are paid the adjusted principal or the original principal, whichever is higher.  So, they even protect you against deflation.  But even though they are a government security, you can still lose money.  As inflation rates rise and fall, so will the value of your TIPS.  If you need to sell prior to maturity you will receive the then-current market value, which could be lower if the CPI has decreased.

If inflation turns out to be less than you expected, the total return on the TIPS could be less than that of a comparable Treasury security without the inflation feature.  That is why TIPS may only be appropriate for part of your bond holdings…and that’s how we’re using them at our firm.

And finally, you should consider taxes.  As the CPI changes, the Treasury will record the changes to your principal every 6 months, but you don’t actually receive any increases until the bond matures.  But the government will tax the increase each year as if you have received it.  If you own the TIPS in a fund, the principal adjustments are paid out on an annual basis and are taxed as short-term capital gains.  That may be a reason to hold TIPS in a tax-deferred account, like an IRA.

TIPS can be a smart addition to a well-diversified portfolio, especially when inflationary times are expected.  For more information, you can contact my office, or you can visit the Treasury’s website at www.TreasuryDirect.gov.