Just the TIPs
The Inflation Trade
Inflation is on the rise, this isn’t new information to most of you as you feel the burn at the grocery store, any textiles you buy, and just about everywhere else. As you can see by the chart below, the rate is still elevated, but what this doesn’t take into account is the compounding nature of inflation.
The media and investment professionals love to emphasize the CPI rate, which is essential, but let's not forget that as long as it’s positive, that’s the increase year over year. So just because it’s down from 8% this year, doesn’t mean inflation is down, it just means it is growing slower. You still got screwed by the 8% last year, and this year you are only getting screwed by 6%….yay? You're still starting from the elevated prices from last year. Again the lower inflation is great…but let’s not pretend prices are falling.
There are a few ways to protect against the inflation bear though, First is Gold and Silver. These are my personal favorite, but they have no real yield, so they catch a bad rap. After that, there are TIPS, which are government bonds specifically designed to protect against inflation. This will be a fairly detailed explanation of them, and why they are useful.
Treasury Inflation-Protected Securities (TIPS) are a popular investment vehicle that offers a hedge against inflation, helping investors preserve the purchasing power of their money. This essay explores the role of TIPS in hedging against inflation and how they can be a valuable addition to an investment portfolio.
TIPS are issued by the U.S. Department of the Treasury and are designed explicitly to protect investors from inflation. They are similar to traditional Treasury bonds, with one significant difference: the principal value of TIPS is adjusted for inflation. This adjustment is based on changes in the Consumer Price Index for All Urban Consumers (CPI-U), a widely used measure of inflation in the United States. As inflation increases, the principal value of TIPS is adjusted upwards, and as inflation decreases, the principal value is adjusted downwards.
How TIPS Hedge Against Inflation
The inflation protection provided by TIPS comes from two primary mechanisms:
Principal adjustments: As mentioned earlier, the principal value of TIPS is adjusted based on changes in the CPI-U. When inflation rises, the principal value of TIPS increases, which in turn results in higher interest payments. Conversely, when inflation falls, the principal value decreases, leading to lower interest payments. This feature ensures that the real value of the investment remains constant, regardless of changes in inflation.
Fixed interest rate: TIPS pay a fixed interest rate, which is set at the time of issuance and remains constant throughout the life of the security. The interest payments are calculated based on the adjusted principal value, meaning that as the principal value increases with inflation, so do the interest payments. This ensures that investors receive higher interest payments during periods of high inflation, helping to preserve the purchasing power of their investment income.
Benefits of TIPS in an Investment Portfolio
TIPS offer several advantages for investors seeking to hedge against inflation:
Inflation protection: As explained above, TIPS provide a direct hedge against inflation by adjusting the principal value and interest payments based on changes in the CPI-U. This helps investors maintain the real value of their investments and protect their purchasing power.
Low risk: TIPS are backed by the full faith and credit of the U.S. government, making them a relatively low-risk investment. This makes them an attractive option for conservative investors and those looking to diversify their portfolio with a low-risk asset.
Tax advantages: While the interest payments on TIPS are subject to federal income tax, the inflation adjustments to the principal value are not taxed until the security is sold or reaches maturity. This can offer potential tax advantages for investors, depending on their individual tax situation.
In an economic environment characterized by inflationary pressures, Treasury Inflation-Protected Securities (TIPS) can serve as a valuable tool for investors looking to hedge against inflation and preserve their purchasing power. By adjusting the principal value and interest payments based on changes in the CPI-U, TIPS provide a direct hedge against inflation and can help investors maintain the real value of their investment. With their low-risk profile and potential tax advantages, TIPS can be a suitable addition to a diversified investment portfolio.