There is a flight to quality underway in the financial markets and U.S. Treasury bonds called “Governments” are the traditional place to hide when Godzilla roams Wall Street. But over the last six months Treasury Indexed Protected securities, called TIPs have proven to be an even more popular and lucrative haven. TIPs offer a hedge against inflation, safety and a chance to profit from future cuts in interest rates.
TIPs are U.S. government guaranteed securities whose principal and interest payments are indexed to the rate of inflation. Although they have been-around since 1997 they have not caught on with the retail- investing crowd largely because inflation has been well contained during this economic cycle. Now, however with oil kissing $100/BBL, gold (a traditional inflation hedge) at all time highs and basic stables, like milk, soaring in prices, inflation has returned with a vengeance.
TIPs partially remove one of the main risks to bond buyers, inflation risk. The twice-yearly interest payments on TIPS are indexed to the Consumer Price Index, the government’s main inflation barometer. If inflation ratchets up like it has over the past few months, the bonds interest payments and principal increases by a like amount. TIPS are sold in $1,000 increments through electronic auction and are issued in terms of 5, 10, and 20 years. They can be held to maturity or sold in the secondary market. Most individual investors prefer to buy TIPs through a broker or invest in TIP funds called ‘real return’ mutual funds offered by Pimco, Fidelity, Vanguard and half a dozen other big fund managers.
As fears of recession pummel stocks and credit concerns make even the most AAA rated corporate bonds suspect, the appeal of the U.S. Treasury market grows ever stronger. Government bonds, unlike everything else, have no default risk. Your principal investment is safe from bankruptcy. That doesn’t mean they are riskless. You still have inflation risk (unless you invest in TIPS) and all bonds have interest rate risk.
Bond prices and interest rates have an inverse relationship. Interest rate risk for a bond buyer occurs when rates go up. That causes the price you paid for your bond to immediately adjust downward. Of course, the opposite occurs when rates drop. Buyers benefit as their bonds increase in price so you want to own bonds of any sort when the Federal Reserve cuts interest rates as they have been doing since the fall of 2007.
Some Wall Street experts believe we are already in a recession and are predicting rate cuts of as much as 1.75% over the next several months to stimulate the economy. These same pundits believe that the rate cuts will cause even higher inflation. It’s an environment tailor-made for a government-guaranteed, inflation-indexed security like a TIP. Is it any wonder that they have suddenly become popular?
So where’s the catch? Because so many investors are buying into these bonds the return on TIPs is dropping. They are only yielding 1.7% or so down from 2 plus percent historically. Compare that to a Federally insured money market fund where you can get upwards of 5% right now.
There’s also a tax issue involving “Phantom Income”, the subject of a future column. For now, just know that TIPs are best bought in tax-deferred accounts like IRAs and 401(K)s.
And then there’s the controversy over the CPI itself. Many economists argue that the index understates the true rate of inflation considerably. If so, that would reduce the bond’s inflation protection features to some extent.
Investors in TIPs are aware of the drawbacks but are betting that the economy sinks into recession, the credit crisis forces more bankruptcies and the fed cut rates in response. That will create higher inflation and so the prices of their TIPs investments will continue to move up. Right now that doesn’t seem like a bad bet.