TIPS for Inflation Protection Today

by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
June 19, 2009

Are you worried that rising inflation will sap the purchasing power from your portfolio? If you answered “yes,” you’re not alone. One of the most frequent questions we’ve heard lately is, “Deflation may have been a risk recently, but what do we do if inflation rises? Can the Treasury really keep printing money without causing problems with inflation later, or driving up interest rates beyond their control?”

If you’re worried, some bond-related investments can provide inflation protection today. TIPS, or Treasury Inflation-Protected Securities, are the most significant. We’ll also touch on a few alternatives quickly, including Series I Savings Bonds issued by the U.S. Treasury.

What are TIPS?
First issued in 1997, TIPS are Treasury securities whose principal and coupon payments are indexed to inflation, as measured by the Consumer Price Index (CPI). Like standard Treasuries, TIPS are issued with a fixed coupon interest rate. However, unlike Treasuries, the principal is adjusted to reflect the inflation rate.

If inflation goes up, the amount of principal due at maturity rises. The coupon payments also rise, as the interest rate is calculated based on this higher principal amount. Plus, when TIPS mature, investors receive their original principal plus the increase based on the amount of inflation over the life of the security.

How Principal Adjustment Works

Date 5/15/2009 5/15/2010 5/15/2011 5/15/2019

Maturity 5/15/2019 5/15/2019 5/15/2019 5/15/2019

Original Pricipal $1,000 $1,000 $1,000 $1,000

Coupon Rate 3.125% 3.125% 3.125% 3.125%

Inflation (CPI-U)* -- 2% 2% 2%** --

Adjusted Principal -- $1,020 $1,040 -- $1,219

Cell 7:1 Cell 7:2 Cell 7:3 Cell 7:4 Cell 7:5 Cell 7:6

Coupon Payments (annual)** -- $31.88 $32.51 $38.09

Coupon Yield -- 3.2% 3.3% 3.8%

Principal Repaid at Muturity $1,219

*Adjusted based on actual inflation, represented by consumer price index (CPI).
**Example assumes 2% annual inflation each year to maturity.
***Coupon payment = coupon rate x adjusted principal

If there’s deflation, the value of principal declines, but there’s a floor at the original face (or par) amount when the bonds were issued. So your principal can’t decrease below that original investment—you’re protected from deflation as well, if that’s a concern.

Many investments, like stocks and real estate, tend to generate returns in excess of inflation over time. If they didn’t, few investors would find them appealing at all. TIPS don’t provide returns that greatly exceed inflation, but they provide a promise to keep up, at least, if inflation rises. And they’re typically less volatile than stocks.

When to buy them?
TIPS are also a good indicator of what the market expects of future inflation. For the latest “break-even” inflation numbers implied by TIPS, simply look up the latest Treasury yield, the latest TIPS yield for the same maturity, subtract the second from the first, and you’ll know the break-even inflation during that time period.

	Treasury Yield	TIPS Yield	Break-Even Inflation Rate
Five-year bonds	2.82%	1.24%	1.58%
10-year bonds	3.81%	1.90%	1.91%
30-year bonds	4.60%	2.28%	2.32%

Note: TIPS will return the yield reported in daily market news (also called the "real" yield, meaning after inflation), plus any future inflation adjustments, to determine the actual return. Source: www.bloomberg.com/markets/rates/index.html, as of June 18, 2009.

If inflation exceeds that break-even inflation rate during that time period, TIPS held until maturity will produce higher total returns than a standard Treasury of the same maturity. If inflation is less, standard Treasuries will do better.

Over time, this relation between TIPS and Treasuries varies. When you believe that pricing underestimates likely inflation in the future, it could be time to buy.

U.S. Treasuries vs. TIPS
U.S. Treasuries vs. TIPS Chart

Lock in "real" returns

Because TIPS provide a guaranteed return after inflation, whatever inflation is in the future, you’re guaranteed to receive at least that quoted yield (typically a few percentage points below a regular Treasury) plus any adjustment that’s needed to keep up with inflation later. This guaranteed return after inflation is often called the “real” yield, as opposed to a “nominal” yield, which is the rate paid on a regular Treasury bond without any adjustment for inflation later. A regular Treasury bond will generate a higher stated yield, but you could have a negative real return if inflation grows too fast.

For example, a Treasury bond with a stated yield of 4% would have a “real” return of 1% if inflation is 3%... 4% - 3% = 1%. A TIPS bond with a stated yield of 2% would have a “real” return of 2%, because it’s promised after the rate of any future inflation.

So it makes sense to buy TIPS with the stated “real” yield is as high as possible. That way, you lock in that future “real” return. Unfortunately, the “real” return on TIPS—the stated yield today—is relatively low today. This reflects the current low interest-rate environment (which, itself, is partly based on future inflation expectations).

Who should buy TIPS?
In addition to the inflation protection benefits, you should be aware of some other features, as well. Over time, TIPS yields are usually slightly lower than Treasuries, if inflation is in line with market expectations. The market will generally pay a premium—that is, accept a lower yield—for the extra benefit of the inflation protection.

TIPS also occasionally experience bouts of price volatility based on shifting expectations of future inflation rates. For example, recently, we’ve been worried much more about deflation, so the demand for TIPS dropped along with prices.

Price Changes in TIPS and Treasuries

As investors have turned their attention to fears of inflation rather than deflation, prices have started to recover and the prices of TIPS have risen. Still, they continue to make sense for a portion of your fixed income portfolio. Under any conditions, they offer a good hedge, especially if you’re in retirement and don’t have growing income now.

Additional factors
Since TIPS are U.S. government obligations, there isn’t risk of default. As with any bonds, however, a rise in interest rates would decrease the value of existing TIPS. When interest rates rise, TIPS lose value, like Treasuries or any other bond investments. They tend to do so a little less, however, because of the inflation protection, and the fact that interest rates and inflation usually rise hand-in-hand.

It’s also best to own TIPS in your IRA or other tax-advantaged account. In addition to your interest earnings, the periodic inflationary adjustment to you principal is subject to ordinary federal income tax. You won’t be paid for this increase until the bond matures, so you’d have to make that tax payment with other cash on hand.

TIPS vs. Treasuries: What’s the Difference?

	Guaranteed by U.S. Treasury?	Quoted Yield	Inflation Protection	Return if Future Inflation Higher than Expected	Return if Future Inflation Lower than Expected	Maturities Available
Treasuries	Yes	Higher	No	Lower	Higher	1 month to 30 years
TIPS	Yes	Lower	Yes	Higher	Lower	5, 10, 20 years

To invest in TIPS, you can purchase individual bonds on Schwab.com—the minimum investment is $1,000—or invest in a high-quality TIPS mutual fund. For suggestions, see the Schwab Mutual Fund OneSource Select List®.

When shopping for individual TIPS, remember, the quoted yield to maturity is the promised return after inflation, whatever it might be in the future. So it will always be lower, and not comparable, to the quoted yield on other non-inflation-adjusted bonds.

Other bond-related inflation alternatives

In addition to TIPS, there a few other types of inflation-adjusted investments that you might consider as well. Series I Savings Bonds (or I-Bonds) are a type of Savings Bond issued by the U.S. Treasury, and vary slightly from TIPS.

Differences include:

I-bonds are sold with a fixed interest rate, which never changes, plus an inflation adjustment. The fixed interest rate at issuance stays the same, plus any benefits from future inflation adjustments.
If there's deflation, the inflation adjustment could be negative, offsetting the fixed interest rate. However, the Treasury guarantees that the value will not decline below the value of the month before, so the value can't decline.
Unlike TIPS, I-Bonds don’t pay regular interest. Instead, the interest builds up over time (“accrues”) until the bond matures.
The maximum maturity for an I-Bond is 30 years from the time of purchase. Or you cash it in before maturity, with a bank or the Treasury directly.
If you cash in your I-bond sooner than five years after purchase, you’ll give up three months’ interest. You must hold them for at least six months after purchase.
Unlike TIPS, there’s no active secondary market for I-bonds. So, unlike TIPS, there’s no volatility in price.

Other issues to consider when deciding whether I-bonds might be right for you:

It makes sense to buy I-bonds when the announced fixed rate is particularly high. That fixed rate stays the same over the life of the bond, adjusted for any inflation/deflation adjustment later. As of this writing, the fixed-rate on a new-issue I-bond was actually 0.10%—so it’s not a very good time to buy now.
Taxes are deferred until you redeem the bond. In contrast to TIPS, they make more sense in a taxable account. And like TIPS, interest is exempt from state and local income tax.
Purchases of I-Bonds are limited to $10,000 per year per investor.

Last, you can find some inflation protection in short-term or adjustable-rate bonds. While their returns are low today, short-term bonds can be rolled over into higher-paying bonds as rates rise (as they typically do, with inflation); and adjustable rate bonds will adjust.

While not really insurance against unexpected inflation, both short-term and adjustable-rate bonds would limit your exposure to rising interest rates later, if inflation—along with market interest rates, which often move hand-in-hand—rise. For both, you can choose a mutual fund, starting with ideas from the Schwab Select List.

Have questions? For more information or to shop for individual TIPS bonds, speak with your Schwab consultant or a Fixed Income Specialist at 800-626-4600.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. See Schwab.com for more recent performance.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors. When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. There is no guarantee that a bond's yield to call or maturity will provide a positive return over the rate of inflation.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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