Record government borrowing and the Federal Reserve’s decision to start raising interest rates have many people fearing a spike in inflation. The Federal Reserve has kept interest rates extremely low in an effort to stimulate the economy. If the economy rebounds and inflation returns, how will the Fed be able to combat inflation without killing the economic recovery?
Some pundits are saying that you should own gold to protect yourself from inflation. Yet, gold has historically not been a very good inflation hedge. Gold prices are relatively high even though they have declined from the peak in 2011. If you are concerned about inflation, a better hedge may be Treasury Inflation-Protected Securities (TIPS).
The Role of Bond laddering
Those who owned bonds in 1994-1995 remember what it was like when interest rates started rising and bond prices fell. While that is not likely to happen overnight, given the slow pace of the economic recovery and very low inflation, it is good to be prepared. The 10-year treasury was yielding around 2 ½% in mid-December. Some forecasters believe interest rates will rise 1% over the next 12 months. The value of a 10-year bond could fall 5-7% to adjust for the higher rates.
This does not mean that we advocate avoiding bonds for any portion of an investment portfolio. Bonds play an important role in our investment strategy. We use bonds to stabilize principal and store a portion of the gains from the equity portion of the portfolio when the stock market is rising. This is accomplished through a fixed income technique called “laddering.”
Laddering assures that a portion of the fixed income portfolio is maturing on a regular basis. Since bonds mature at face value the maturing bonds are not affected by rising interest rates. The proceeds of the matured bonds can be used to meet a client’s liquidity needs, buy equities if the stock market is down, or buy a new bond if the portfolio is already balanced.
Using bonds in the face of possible future inflation
Bond prices fluctuate with interest rates. Interest rates react to the 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 up with bond prices.
The collapse of the equity markets in 2008-2009 encouraged risk adverse investors to buy bonds. A lot of them. And they were rewarded with rising principal value in their bond holdings as interest rates and inflation continued to fall.
Treasury Inflation-Protected Securities (TIPS)
The above scenario could be changing once our economy gets back on track and the Federal Reserve follows through with rate hikes. TIPS are also called “anti-bonds,” because the original principal (face value) 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 hedge against inflation. The real purchasing power of the interest payment moves higher to account for changes in inflation. In comparison, a traditional bond 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.
Assuming inflation continues, a good example of a TIPS investment would be when investors set 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.
Tax characteristics of TIPS
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 considered to be free from credit risk; however, their price will move up and down with interest rates like other bonds.
The risk to a bond portfolio can be managed if it is done properly. You should be taking steps today to minimize the impact of higher interest rates on your fixed income holdings.
- Rising interest rates will cause the value of current bond positions to decline.
- Bonds mature at face value no matter what happens to interest rates as long as the issuer doesn’t default.
- Treasury Inflation-Protected Securities (TIPS) offer a true hedge against inflation.