Headline: I have some hot TIPS for you…

Date: 1/25/2021

Body:  I was looking around for some good investments, and I have a contrarian recommendation.   In fact, I am going to change my policy here and give you some hot TIPS.  That’s it, right there.   See you later.

Oh, you need a bit more, OK.   TIPS stands for Treasury Inflation Protected Securities.   They are very important when inflation is very high.   So, there is currently no buzz about this in the media.   The current inflation rate is near 0, and by all indications, the Fed is not going to increase rates anytime soon, so, nobody is crowing from the rooftops, exclaiming how incredibly brilliant they are to have invested here; and that is exactly my point.    This is the exact economic position where TIPS are inappropriate, and that makes them cheap.   Hence, your opportunity.   Said one expert,

 Whether TIPS are worth it depends a lot on the economic landscape. The big factors are stock-market performance and how much inflation the bond market is pricing in, says Tony Crescenzi, chief bond market strategist for Miller, Tabak & Co. and author of The Strategic Bond Investor (McGraw-Hill, $29.95).

OK, so what are these things called TIPS  and how are they used in a portfolio?

TIPS are Treasury Inflation-Protected Securities, which means that their objective is to preserve purchasing power of one’s assets in an environment of rising prices.  Confusing?    Let me give you an example   Picture a sailboat, out at sea.  In this metaphor, the tide would represent the inflationary pressures in the economic environment; It would raise and lower our boat.   The boat itself represents the value of the principle of TIP security, as it rises and falls on the inflationary environment.  The sail provides the force that pushes the boat forward, just as interest payments  do in our metaphor.  So, even though the shape and quantity of sail does not change (interest rate) based on the principle changing, the payment will.

What do I have to think about before I invest in TIPS?

Pros

• The principal increases with inflation meaning that at maturity, bondholders are paid the inflation-adjusted principal
• Investors will never be paid less than their original principal when TIPS mature.   Said another way, the investor will always get back at least the principal they invested; principal amount ONLY ratchets up.
• Interest payments increase as inflation increases since the rate is calculated based on the adjusted principal balance.  Remember, the sailboat?   The sail area remains the same, but, the boat is now higher, and catches the wind better, and goes faster.  This increase in velocity can be thought of as the increase in interest payments.

Cons

• Interest rate offered is usually lower than most fixed-income bonds that do not have an inflation adjustment.   More particularly, the yields on corporate bonds (even the really high-quality ones) are usually significantly higher.
• Investors might be subject to higher taxes on increased coupon payments
• If inflation does not materialize while TIPS are held, the utility of holding TIPS decreases
• If there is an increase in principal value, the increase is taxed each year UNLESS these are held in a non-taxable investment vehicle.

How do I go about buying TIPS?

TIPS can be purchased from TreasuryDirect.   New securities are auctioned off in a sequence of months in a competitive bidding scenario.  For instance, in January, they might auction only the 5-year and 10-year securities.  In February, they might be auctioning only 30-year TIPS.  There might also be some non-competition auctions that ensure that each investor gets something.

How do I eventually sell my TIPS?
TIPS may be held until maturity or sold at any time through a securities broker or the U.S. Treasury’s Sell Direct program. TreasuryDirect gets an agent to execute the sale and charges a commission of $34.    A confirmation of the sale is transmitted to the seller, and a roll-up of these transactions is presented in a F.1099 annually.

TIPS also qualify for the Treasury’s Separate Trading of Registered Interest and Principal of Securities (STRIPS) program.  Under this program, the principal and interest rights can be sold separately. If held for the entire term, the bond will be redeemed at the adjusted principal balance.

How are TIPS taxed?

TIPS generate revenue for the investor in 2 ways: principal and interest.   The interest payments are made semi-annually, and information on these transactions is rolled up into an annual F. 1099-INT.   Adjustments to the principal are taxed immediately, and rolled up int an annual F. 1099-OID.

There is one other cost when TIPS are involved. The Treasury imposes an annual maintenance fee of $25 on accounts of more than $100,000. This fee may be deductible, subject to the investor’s limit on miscellaneous itemized deductions.

The Verdict

TIPS are something to consider for a part of your portfolio.  They are probably not as important as stocks for growth, and probably not as good as corporate bonds for income.   But, they ARE really handy to have in some economic conditions, like rapidly increasing inflation.  As we are at 0% now, and inflationary pressures seem high (and the Fed suggested that it is unlikely they will change the interest rates any time soon), now might be just the time to add these to your investment mix.  Just understand that they should likely represent a small percentage of your investable assets.   If you are piloting a sailboat, your trip goes a lot smoother if you have a massive, stabilizing keel.

P.S. It would appear quite possible (perhaps probable) that our future could hold significant inflation. If true, then, these securities might make even more cents… er… um… I mean sense.

REFERENCES

Treasury Inflation-Protected Securities (TIPS) Definition (investopedia.com)

Treasury Inflation-Protected Securities, Explained (thebalance.com)

TIPS and CIPS (journalofaccountancy.com)

Tips for Investing in TIPS | Kiplinger

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.