Those who’ve forgotten the runaway inflation of the late 1970s might be lulled into thinking today’s low inflation rates can go on forever. Pat Mauro knows better.
Mauro, president of Oak Brook’s Patrick Mauro Investment Advisor Inc., notes that since the end of World War II the 10-year rolling rate of inflation has rarely dipped below 2 percent. That suggests last year’s inflation rate of 1.6 percent won’t be repeated often in the years ahead.
Inflation has historically been strongly correlated with the price of oil, which could be affected by a Middle East war, Mauro observed. What’s more, war itself is inflationary. And the weakening dollar, which has fallen about 11 percent against other world currencies since July 2001, tends to be inflationary, because imports cost Americans more, he noted.
All of which helps explain why Mauro regularly touts Treasury Inflation-Protected Securities, or TIPS.
“Even though inflation is low right now, historically you cannot count on low inflation staying with us,” he said. “And that’s the beauty of these bonds. It’s just a hedge against inflation. They do guarantee a real rate of return. Even if we have deflation, they’ll give you back your original principal and you’ll receive interest on the deflation-adjusted price.”
TIPS are Treasury bonds that pay not just a fixed coupon rate but a fixed coupon rate plus the inflation rate. The fixed return is established at the time of the investment, and the total return earned is the fixed return sweetened by the recent rate of inflation.
To offer a simple hypothetical example, imagine an investor buying a TIPS bond for $1,000 with a 3 percent real rate of return, said Pete Hollenbach, spokesman for the Treasury Bureau of the Public Debt in Washington, D.C.
“At the end of six months, there’s been 2 percent inflation, so we would adjust the principal value of the TIPS so it is now $1,020. And we would pay the interest payment on that. At 3 percent it would be $15.30.”
If another 2 percent inflation was recorded over the next six months, at the end of 12 months the principal would be $1,040, and the investor would be paid 3 percent or $15.60, Hollenbach explained. “So your principal and interest are both adjusted for inflation,” he added.
That adjustment is important, because savvy investors look at expected returns on their investments relative to inflation rates, said Chandan Sengupta, the White Plains, N.Y.-based author of “The Only Proven Road to Investment Success” (John Wiley & Sons, 2002).
When they purchase regular fixed coupon bonds, the longer the maturity, the greater risk of inflation they assume. If inflation rises, interest income doesn’t keep pace.
“The advantage of the TIPS bond is it will always keep pace with inflation and pay you something more than that,” Sengupta said. “It will pay you a fixed real return, as it’s called.”
Introduced in January 1997 by the U.S. Treasury, TIPS have become increasingly popular recently. And there are good reasons for that.
For one, the late 1990s was an era in which many investors, hungry for huge gains in the stock market, avoided fixed-income securities. It took a plummeting market to return them to the notion bonds were worth considering.
Another factor is that TIPS have now been around long enough for investors to become aware of their benefits, said Hollenbach.
“Like any new security, it takes folks a while to get used to them,” he said. “It’s a very different idea. It takes a little while for the marketplace and the public to understand what those securities can do for them.”
Concerns about a return of inflation may also be fueling interest, said Mark Rosenberg, senior vice president and wealth adviser with Morgan Stanley in Greenwich, Conn.
“Inflation is the enemy of retirees and bondholders,” he noted. “If you include TIPS in a portfolio, then rising inflation becomes your friend. That’s the way people think about it. Investors understand that inflation is a long-term problem when you’re on fixed incomes.”
Investors won’t get rich investing in TIPS. But for many long-term investors, there’s wisdom in allocating a percentage of their portfolios, particularly their tax-advantaged portfolios, to TIPS.
While the returns on TIPS may be equaled by conventional Treasury bonds and surpassed by corporate bonds over a period of just a few years, beyond that time inflation is sure to devour some of the returns on other fixed-income instruments.
“To the extent that you should have a portion of your money in fixed-income securities as you get closer to retirement, this is a very attractive option,” Sengupta said.
“Anyone who wants a percentage of their portfolios in fixed-income securities and wants a maturity of more than five years, they’re safer with TIPS than regular Treasury bonds.”
One additional benefit of TIPS is that state and municipal taxes don’t have to be paid on U.S. Treasury securities, Sengupta added.
Looking at the downside
However, TIPS also carry a couple of disadvantages. The big one is that investors have to pay taxes on the semi-annual inflation adjustment each year, even though they don’t receive it until they sell the bond or it matures.
It’s this taxable “phantom appreciation,” as Mauro terms it, that leads many investors to reserve TIPS for tax-advantaged accounts, such as 401(k)’s, 403(b)’s, conventional IRAs, SEPP IRAs and Roth IRAs.
“If you’re holding it in a taxable account, you have to come up with that tax money from some other source,” Sengupta said.
“One way of getting around that is instead of buying TIPS themselves, buy TIPS funds. The fund distributes cash equal to the fixed-interest income plus the inflation adjustment, so you’ll get enough money to pay taxes.”
The second disadvantage is that TIPS can be harder than other fixed-income securities for the individual investor to understand.
Even more than with many other investments, individuals must arm themselves with knowledge before investing. Because of the complexity of TIPS, Sengupta doesn’t recommend individual investors buy and sell them.
If investors aren’t concerned about the tax ramifications and are interested in buying and holding TIPS for the long term, he urges them to buy TIPS directly from the U.S. government at the time of auction. For information, visit www.treasury.gov.
Others interested in TIPS should confine their investing to TIPS funds, but make sure they purchase low-cost funds (with less than 0.5 percent expense fees) offered by such names as Vanguard or TIAA-CREF, Sengupta said.
