Inflation Alert: Consider Investing in TIPS
Tax PlanningThe Fed is finally taking aggressive action to fight inflation, but will it work?
Where’s the stock market headed?
Who knows?
Real estate might be a good inflation hedge, but it’s a non-liquid asset and no sure thing.
Clearly, this is not a great environment for investors or retirement savers.
If you are thinking of investing conservatively but in a way that also offers some inflation protection, here’s an option to consider.
Treasury Inflation-Protected Securities
U.S. Treasury Inflation-Protected Securities (TIPS) are a special variety of Treasury bonds that are adjusted for inflation.
Specifically, in times of inflation, TIPS principal balances are adjusted upward twice a year, based on changes in the Consumer Price Index.
In contrast, significant inflation can punish the conservative investment strategy.
Okay, sounds interesting. How do TIPS work?
TIPS Basics
TIPS are sold at original issuance with terms to maturity of five, 10, and 30 years. They pay cash interest twice a year at a fixed rate that’s set at issuance.
Also, as we mentioned above, during times of inflation, TIPS principal balances are adjusted upward twice a year.
You receive the following if you hold a TIPS bond:
- Cash interest payments twice a year at the stated fixed rate. Each semiannual payment equals half the stated rate times the inflation-adjusted principal balance at the time of the payment. So, cash interest payments go up with inflation because they are based on the increasing inflation-adjusted principal balance.
- At the date of maturity, you receive the inflation-adjusted principal balance.
Reality Check
As this was written, TIPS bonds maturing on July 15, 2027 (five years and two weeks later) that pay a fixed annual interest rate of 0.375 percent were trading at 99.554 in the secondary market. The inflation-adjusted principal balance factor for these bonds was 1181. Therefore, the price for one of these bonds with a par value of $100,000 was $117,573 ($99,554 x 1.181).
If there’s significant inflation, the twice-yearly interest payments will increase as the inflation-adjusted principal balance goes up. But the interest payments still won’t amount to much because the fixed annual rate is so low (0.375 percent).
If there’s significant inflation, the real money is earned from the fact that the principal balance will be adjusted for inflation. If you hold the bond to maturity, you’ll collect the twice-yearly inflation-adjusted cash interest payments plus the inflation-adjusted accrued principal balance as of July 15, 2027. If you sell before maturity in the secondary market, you’ll get what you get. No guarantees.
The Deflation Scenario
While deflation might seem highly unlikely at the moment, nothing is certain these days. Right?
During periods of deflation, TIPS principal balances are adjusted downward twice a year. The twice-yearly interest payments are also adjusted downward—because they are based on a declining adjusted principal balance. The stated fixed interest rate itself doesn’t change.
But even in the worst-case scenario of significant deflation during your ownership period, the results of owning a TIPS bond won’t be catastrophically bad, as long as you hold the bond to maturity. That’s because you’re guaranteed to receive at least the face value of the bond at maturity, even if the adjusted principal balance has fallen below that number. If the inflation-adjusted principal balance exceeds the face value, you’ll receive the larger
inflation-adjusted number.
So, in Example 2, you would collect at least $100,000 when your TIPS bond matures on July 15, 2027—even if there’s significant deflation during your ownership period of five years and two weeks. This is certainly not a good result, because you paid $117,600 for the bond and only earned minimal interest while you owned it.
Ways to Invest in TIPS
The minimum face value for a TIPS bond is $1,000. Larger denominations are available in $1,000 increments.
Original Issue
You can purchase TIPS upon original issue directly from the government, through the online TreasuryDirect program.
The TreasuryDirect option is available only for TIPS purchased for taxable accounts. You cannot use a tax-favored retirement account, such as an IRA, to buy TIPS upon original issue via TreasuryDirect.
If you buy a newly issued TIPS bond via TreasuryDirect, you’ll receive at least the face value of the bond if you hold it to maturity, even if there’s significant deflation.4 In other words, if you buy $100,000 of bonds via TreasuryDirect and hold them to maturity, then you receive no less than $100,000.
Secondary Market
TIPS are marketable securities, so you can buy previously issued TIPS bonds in the secondary market through your friendly neighborhood brokerage firm.
If you buy older TIPS in the secondary market and pay for the inflation adjustment to the principal balance, as illustrated in Example 2, that adjustment can vaporize with deflation. The way to avoid this risk is to buy TIPS at original issue or on the secondary market shortly thereafter.
Warning. As with other Treasuries, secondary market prices for TIPS bonds fluctuate due to changes in prevailing interest rates, supply and demand, and other factors.
Other things being equal, however, the following are true:
- The secondary market price of TIPS will go down when the yield on regular Treasuries goes up, because that reduces the inflation-protection advantage of TIPS.
- The secondary market price of TIPS will go up when the yield on regular Treasuries goes down, because that increases the inflation-protection advantage of TIPS.
If you don’t intend to hold your TIPS to maturity, please understand that market prices can and do change on a daily basis. And there’s no certainty about how much you can sell your TIPS for in the secondary market. You’ll get what you get. May the force be with you.
TIPS ETFs
A simpler alternative to direct ownership of TIPS is buying shares in an exchange traded fund (ETF) that invests in a basket of TIPS bonds that simulate the results from direct investments in TIPS.
You can hold TIPS ETFs in a tax-advantaged retirement account or in a taxable brokerage firm account. TIPS ETFs usually pay monthly distributions. But distributions may be skipped in times of deflation.
- Broad-spectrum TIPS ETFs include the iShares TIPS Bond ETF (TIP on the NYSE), the Schwab U.S. TIPS ETF (SCHP), and the PIMCO Broad US TIPS Index ETF (TIPZ).
- One medium-term maturity TIPS ETF is the SPDR Bloomberg Barclays 1-10 Year TIPS ETF (TIPX on the NYSE).
- Shorter-term maturity TIPS ETFs include Vanguard Short-Term Inflation-Protected Securities ETF (VTIP on the Nasdaq) and the iShares 0-5 Year TIPS Bond ETF (STIP on the NYSE).
- The total return from holding a TIPS ETF depends on the distributions that you receive (usually monthly) and on share price appreciation or depreciation. As investors have discovered this year, share prices can go down or up depending on bond market changes. Significant downward moves have occurred this year.
- Share prices of ETFs that hold longer-term TIPS are more volatile than those that hold shorter-term TIPS.
Key point. We are not endorsing any of these ETFs. They are mentioned for information purposes only.
As examples of the recent performance of a couple of TIPS ETFs, SCHP had a YTD total return of -8.26 percent as this was written. VTIP had a YTD return of -1.12 percent. Ugh, so far.
But SCHP had a total return of 5.86 percent in 2021, 10.94 percent in 2020, and 8.36 percent in 2019. VTIP had a return of 5.32 percent in 2021, 4.97 percent in 2020, and 4.83 percent in 2019.
TIPS Tax Considerations
Cash interest payments from TIPS and non-cash increases in the principal of TIPS are subject to federal tax at ordinary income rates, but exempt from state and local income taxes.
TreasuryDirect and the brokerage houses report the TIPS amounts subject to the federal income tax on two information forms:
- Form 1099-INT shows the sum of the semiannual cash interest payments made to you in a given year.
- Form 1099-OID shows the amount by which your TIPS principal amount increased or decreased due to inflation.
Negative Adjustment
Remember, if deflation occurs, the Treasury Department adjusts the principal balance of the TIPS bond downward (but not below the original issue price).
For tax purposes, a negative principal balance adjustment first reduces taxable interest income from cash interest payments received in the year of the adjustment. If the negative adjustment exceeds the cash interest payments, you can generally claim the loss to the extent there was previous taxable interest income from cash interest payments. Any remaining negative adjustment is carried forward to reduce taxable income from cash interest payments in future years.
TIPS ETF
When you hold a TIPS ETF in a taxable account, the distributions that you receive (usually monthly) are generally high-taxed ordinary income.
But some distributions may include lower-taxed long-term capital gains. If you sell a TIPS ETF for a gain or loss, it’s a short-term or long-term capital gain or loss, depending on how long you held the shares.
Tax Planning Consideration
When you hold a TIPS investment with TreasuryDirect or in a taxable brokerage firm account, the cash interest payments and any positive inflation adjustments to the principal balance will be high-taxed ordinary income—even though the inflation adjustments are currently not paid in cash.
Paying current taxes on the inflation adjustments is not good, because you won’t actually collect the cash until the TIPS matures or you sell it in the secondary market. In other words, you have to pay taxes on “phantom income.”
You can avoid that problem by holding direct TIPS investments acquired in the secondary market in a tax advantaged retirement account.
Key point. None of this tax stuff matters for TIPS held in a tax-favored retirement account—such as a traditional or Roth IRA, 401(k), or SEP.
Inside the retirement account, the TIPS money you make or lose affects the retirement account balance. On traditional accounts, you pay taxes at ordinary rates when you take withdrawals.
Of course, qualified Roth IRA withdrawals are federal-income-tax-free.
Takeaways
Investing in original-issue TIPS at TreasuryDirect instead of “safe” garden-variety fixed income instruments will pay off if there’s significant inflation and you hold to maturity.
Ditto if you buy TIPS in the secondary market and hold to maturity.
If you sell before maturity, you face the whims of the Treasury bond market and results can vary. For instance, the price of TIPS can drop if the yields on regular Treasuries go up.
If you buy a TIPS ETF, you are also subject to the whims of the Treasury bond market. So far this year, the results from holding TIPS ETFs have not been good.
There’s one tax disadvantage to TIPS investments: you are taxed on phantom income. But holding direct TIPS investments acquired in the secondary market in a tax-favored retirement account avoids the phantom-income tax problem.
In the current investment environment (as with most such environments), there are no sure things. TIPS are no exception, despite the currently raging inflation.
