The bear in the woods for bond investors is rising inflation. Today, while the bear is still in hibernation, it might be a good time to look at some TIPS in case it wakes up and takes a swipe at our bond holdings.
Those who owned bonds in 1994-1995 remember what it was like when the bond market bear awoke and bond prices fell. While that is not likely to happen overnight today, given the slow pace of the economic recovery and very low inflation, it is good to be prepared.
Bond prices fluctuate with the bond market's outlook for inflation. If the outlook projects rising inflation, the real purchasing power of bond interest payments falls and bonds paying a fixed interest rate become less valuable. If inflation is decreasing, the opposite is true-real purchasing power goes with bond prices.
The latter is the case today, with inflation benign and bond yields approaching record lows. The collapse of the equity markets from highs in March 2000 has encouraged risk-adverse investors to buy bonds . . . lots of them. And they have been rewarded with rising principal value in their bond holdings as interest rates and inflation continue to fall.
But that scenario could change once our economy gets back on track. That is why bond investors might want to take a look at the inflation-protected bonds issued by the U.S. Treasury, better known as TIPS (Treasury Inflation-Protected Securities).
It might be a good time to look at some TIPS.
Also called "anti-bonds," TIPS feature a face value that is adjusted with changes in inflation rates. The Treasury then pays interest on the adjusted face value of the bond, ensuring a gradually rising stream of interest payments (assuming inflation continues). At maturity, TIPS investors will receive the original face value plus the sum of all the inflation adjustments since the bonds were issued.
As a result, TIPS offer a true "real return," or the real purchasing power of the interest payment after taking into account changes in inflation. A traditional bond, on the other hand, provides a "nominal return." It maintains a fixed face value until maturity, with no adjustments for inflation. For example, if you receive a 4% interest payment from a bond and inflation is 1.5%; your real return is 2.5%.
TIPS were first issued by the U.S. Treasury in 1997. However, other nations, including the United Kingdom, Canada, Sweden, Australia and New Zealand, have been issuing inflation-protected bonds for a number of years.
A good example of a TIPS investment would be when an individual sets aside retirement funds in an IRA. Purchasing $100,000 in TIPS locks in this amount in real terms. Whatever the inflation rate until the individual's eventual retirement, the $100,000 would be completely "indexed"-its value would be increased to offset any increases in inflation.
TIPS have unique tax characteristics that make them better suited to IRAs or other tax-advantaged accounts. Because you pay tax each year on the annual interest payments you receive as well as the inflation adjustment, if you held the securities in a taxable account, you would pay income tax on money you wouldn't see for years.
TIPS are not without risk. Since they are guaranteed by the federal government, they are free from credit risk; however, their price will move up and down with interest rates.
Life is good for bond investors today, but keep in mind that the time to buy insurance is when you don't need it. This holds true for TIPS as well. Inflation, remarkably under control for the past five years, is the biggest danger a fixed income investor faces.
Contact Saperston Asset Management Inc. at: willard@saperston.com
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