Why You Shouldn’t Overlook TIPS


*If this is your first time here, read this.

 

Summary:

  • Now seems like a good time to get into the risk-free treasury bonds to lock in the high yields before the Fed to starts cutting rates, which the market estimates to be around mid-2024.
  • Yet, it is likely that the era of low inflation, near-zero interest rates is over and >2% inflation, moderate interest rates will be here to stay.
  • Treasury Inflation-Protected Securities (TIPS) can provide a better return when inflation is rising but interest rates are relatively stable/decreasing.

 

Treasury bills/bonds offer a good return on risk-free investment when inflation appears to be easing and interest rates are stable or falling.

But it’s likely that things are going to be more expensive in general.

Inflationary pressures include:

  • high geopolitical tensions: Increases the likelihood and frequency of events like the Red Sea shipping crisis, and businesses spending more to build more resilent supply chains.
  • climate change: investments in clean energy transition, building protections against rising sea levels and rising temperatures and rebuilding/paying for damages caused by extreme weather
  • aging population: less people working, reduced productivity reducing supply of goods and services. Critically,China’s cheap goods which effectively exported deflation to the rest of the world is coming to an end, as she faces her own aging population problem
  • public debt: rising debt burden will cause governments to inflate the debts away

 

While technological breakthroughs like AI and nuclear fusion provide a ‘productivity miracle’, the timing remains uncertain and require significant investment in the meantime.

This means that at least in the near future, inflation will trend higher than lower, and certainly above the near-zero rates we had had in the last decade.

Higher inflation will erode the returns from the treasury bonds. The alternative to keep up is Treasury Inflation-Protected Securities, or TIPS.

 

TIPS are issued by the US Treasury and pay interest twice a year at a fixed rate.

Unlike the usual bonds, the principal of the TIPS is tied to the Consumer Price Index (CPI) which measures inflation. Returns are based on the yearly inflation plus the interest coupon on the adjusted principal.

Let’s say I invest $1M at 2.5%. If after the first year, inflation was 3%, then the adjusted principal is $1,030,000 and the 2.5% coupon applies to this adjusted premium so total return in year one is $55,750, or 5.5% return.

Currently, the 5-year TIPS yield have fallen from a high of 2.55% in Oct’23 to 1.86%. However, as long as inflation on average over the next 5 years is above 2.38%, then the 5-year TIPS continues to return more than the 5-year Treasury right now at 4.24%.

 

But what happens when inflation falls?

When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater. In other words, Investors who buy TIPS at auction when they issued and hold them to maturity will not suffer a loss even during an extended deflationary period when prices fall because they are guaranteed to receive the face value.

Investors who buy TIPS in the secondary market at a price above face value could suffer a loss if the adjusted principal value due to inflation falls below the price paid for the bond.

The biggest risk with TIPS is rising interest rates. Like other bonds, when interest rates rises, the underlying value of the bond decreases.

So the best time to buy TIPS is when inflation is rising but interest rates are relatively stable/decreasing. At current rates of inflation and Fed holding interest rates steady or cutting rates soon, the 5-year TIPS deserves a closer look over the 5-year treasury bond.

 

Disclaimer:

Investing decisions are personal. Depending on your personal circumstances and preference, what works for others might not work for you. Be responsible for your own investments. Always invest according to your own needs and preference.