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The Safest Investment Anywhere—Treasury Inflation-Protected Securities (TIPS)

Inflation poses the greatest danger facing investors who depend on interest income from bonds to meet their living expenses because the level of interest income is fixed at the time you invest in bonds, but the purchasing power of that interest income erodes steadily. For example, if you plan your bond investments under the assumption that inflation will be 2%/year and it turns out to be 4%/year, you will either be able to spend less than you expected, or the purchasing power of your savings will erode faster than you expected. (Inflation has averaged 3.8%/year from 1952–2007,8 which is more than most individuals are counting on for the future. At that rate of inflation, prices double every 18½ years.)

In 1997, the U.S. government offered fixed-income investors the ultimate protection from inflation. That year, the Treasury started selling Treasury Inflation-Protected Securities (TIPS)—bonds whose interest rate was not fixed. Rather, the interest paid by TIPS is reset every six months to be equal to the current inflation rate plus a fixed amount. For example, if you own a 2% TIPS, and inflation during the past 12 months was 3.1%, then the bond paid you 5.1%: the 2% fixed rate plus the 3.1% inflation rate.

TIPS pay this interest in two parts. The fixed, or real, component of the interest income is paid as cash coupon payments every six months. However, the inflation-related part of the TIPS return is added onto the bond's principal. In other words, unlike every other type of bond, the principal value of TIPS after issuance is not $1,000. Rather, the principal in a TIPS is $1,000 adjusted for the amount of inflation since issue.

The attractive feature of TIPS is that your coupon payments rise with inflation. To see why, let's look at an example simplified by the use of round numbers. Suppose you buy a TIPS at its issue for $1,000 that pays 2% plus inflation. At first, your cash interest payments will be $20/year. If there is no inflation, then your interest payments will remain $20/year.

Suppose that after a few years since the issue of this TIPS, consumer prices have increased 10%. Once this inflation is factored into the TIPS you bought for $1,000, its new principal value will be increased by 10% from the $1,000 purchase price, to $1,100. Moreover, the fixed interest payments will also increase. The fixed (or real) interest payment is calculated as 2% of the new principal: 2% of $1,100, which is $22/year. Notice that both the principal of the bond and the rate of interest income have both increased by 10% since the initial purchase, because there has been a total of 10% inflation since you bought the TIPS.

Besides being inflation-proof, TIPS at many times can pay more than regular Treasury notes. For example, in late July 2007, a TIPS maturing in 10 years was paying 2.47% in cash interest plus the increase in bond principal to match inflation. At the same time, a regular 10-year Treasury bond was paying 4.79%. That means that if inflation during the coming 10 years averages 2.32%, the 10-year TIPS and the 10-year Treasury note will return the same. (The TIPS return would be the 2.47% interest rate above inflation, plus the 2.32% increase in principal to match inflation, which would total 4.79%.) During the 1997–2007 period, inflation averaged 2.6%/year, and that was a period of unusually benign inflation. Even if prices continue to rise as slowly as 2.6%/year, as a bond investor, you would get more from a TIPS at current market conditions than from a regular 10-year Treasury note. If inflation averages more than 2.6%/year (as we expect), then the advantages of TIPS would be even greater.

TIPS would be the holy grail of income investing but for two difficulties. First, very few of us can afford to retire solely on the amount of the cash interest payments that TIPS generate. As of this writing, TIPS are paying 2.47%/year plus inflation, which means that you would need $1,000,000 in TIPS to get just $24,700/year in interest payments that will keep up with inflation. As a result, most of you will not be able to rely entirely on TIPS to meet your living expenses without depleting at least some of your investment principal. However, to the extent that you might want to place part of your portfolio in safe investments that you do not need to watch, TIPS are an excellent choice.

Second, unless you hold TIPS in an IRA or other retirement plan account, you have to pay taxes each year not only on the cash interest payment but also on the principal adjustment. In periods of high inflation, a TIPS investor in a high tax bracket could paradoxically owe more money to the government than he received in cash interest. For example, if a TIPS pays 2% plus inflation to an investor in a 35% federal income tax bracket, what would happen to that investor after a year of 4% inflation? The total return on his bond would be 6%, of which 2% is received as cash and 4% is added to the principal value of the bond. The taxes due are 35% of 6%, which is 2.1%—more than the cash received. In order to pay his tax bill, the investor would have to have funds available from another source, or he would have to sell off some of his TIPS (which is most easily accomplished with a TIPS mutual fund).

The real problem with taxes is that they can easily turn TIPS from a guaranteed winner to a losing investment whenever inflation heats up. (The same is also true for a regular bond held in a taxable account.) For this reason, it is preferable to hold TIPS in a retirement account. Because of the expenses involved, we do not recommend holding TIPS in a variable annuity. In addition to buying individual TIPS bonds, there are two low-cost vehicles that hold TIPS: the Vanguard Inflation-Protected Securities Fund (VIPSX) and the iShares Lehman TIPS Bond ETF (TIP). Both of these have an expense ratio of 0.2%/year. Unless you are planning to trade TIPS to profit from the ups and downs of the bond market, we recommend the Vanguard fund over the ETF because there are no transaction costs with the Vanguard fund.

In deciding whether to purchase individual TIPS or one of these two inexpensive TIP investments, you should consider whether you want the security of knowing when your bonds will mature, which would favor individual bonds. On the other hand, if you want the freedom to make withdrawals from your bond account whenever you want, and in whatever amount, then the Vanguard TIPS fund (VIPSX) would probably be the best bet.

However, if you are looking for the ultimate safe investment as part of your portfolio and are not concerned about having current income in hand, individual TIPS could be best. The cheapest way to buy individual Treasury bonds (TIPS as well as regular bonds with fixed coupons) is through the Treasury Direct program, which allows you to buy newly issued Treasury debt without paying any commission. There is, however, an annual account maintenance fee of $25 for accounts above $100,000, and if you sell a bond before it matures, the government charges a fee of $34 for placing the trade with a dealer. (See www.treasurydirect.gov for the specific features of the Treasury Direct program and the dates at which new Treasury bonds are scheduled to be auctioned.)

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