Inflation is here, and though it may be transitory, investors are still evaluating ways to buffer portfolios against rising consumer prices.
One of the most frequently used assets in inflationary environments is Treasury Inflation-Protected Securities (TIPS). In prior eras of inflation, advisors and clients alike flocked to TIPS because these bonds issued by the U.S. government are designed to be responsive to inflation.
Given that TIPS are backed by Uncle Sam, credit risk is essentially non-existent, making the asset class practical for retirees and other investors looking to scale back fixed income risk. Plus, TIPS are easy to understand, even for novice investors.
“Although there are many measures of inflation, TIPS are referenced to one specific index: the Consumer Price Index, or CPI, a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services, published monthly by the U.S. Bureau of Labor Statistics,” says Charles Schwab’s Collin Martin.
Like traditional Treasuries, TIPS are fixed rate bonds, but coupon payments are determined by underlying principal value. Another area of interest for income-seeking clients is what type of yields TIPS offer.
“Most TIPS yields are negative today. While that might surprise many investors, consider the yields of nominal (non-inflation-protected) Treasuries. The 10-year Treasury yield is still positive at 1.5%, but after the rate of inflation is accounted for, that inflation-adjusted yield is below zero, as well,” notes Martin.
However, simply because TIPS sport negative yields that does not mean an investor is assured of losing money with these bonds. Real yields imply the investors will lose relative to inflation, but nominal returns indicate that even incremental increases in inflation provide some support for this type of investment.
“If inflation averaged just 1% per year, the nominal total return on this TIPS would still be positive, as the annual inflation adjustment would offset that annualized negative real yield. The higher inflation goes, the higher the nominal total return of a TIPS can go; the same can’t be said for the total return of a traditional Treasury,” according to Martin.
Indeed, there’s support for TIPS exchange traded funds this year. Investors added almost $4 billion to the Schwab U.S. TIPS ETF (SCHP ) as of June 25.
For more on income strategies, visit our Retirement Income Channel.