 Personal Finance PowerPoint Presentation, Treasury Inflation Protected Securities, or TIPS, prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Treasury Inflation Protected Securities TIPS, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated February 17th, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what are Treasury Inflation Protected Securities, or TIPS? Treasury Inflation Protected Securities TIPS are a type of Treasury security issued by the U.S. government, so they're issued by the U.S. government. Therefore, as an investment, you would think they would be fairly secure, the government having the capacity and ability to handle their debt obligations. This are indexed to inflation in order to protect investors from a decline and the purchasing power of their money. So you oftentimes, when we think about like fixed income type of investments from say the government, like Treasury notes, Treasury bills, Treasury bonds, then we have kind of a fixed rate of return that gives us more exposure or a risk for the interest rate risk, which would mean that if we lock in the interest rate and then market rates go up, then we won't have the money to basically invest in those higher returns. In other words, if we had the money as interest rates go up, we might be able to invest in similar types of investments and get a higher return if the market rate goes up. However, if the market rate goes down, then we're actually benefiting from locking our returns in. So that's kind of how the normal process works. Now you might ask, well, then is there some way that I can get at least some fluctuation in the returns? And so now we've got the inflation protected securities, which as the name suggests, is trying to give some protection with regards to inflation, which is the decline in the purchasing power of the dollar, something that the US government kind of works into the system. Because remember, the Federal Reserve is trying to aim for the dollar to be a fairly steady measuring tool that we can depend on. But in order to do that, they try to overshoot generally by like one to two to three percent, for example. So that means that the kind of stuff that you can purchase with a dollar is actually declining over time in order to try to handle the money supply would be the idea. So as inflation rises, which is generally the case, rather than their yield increasing tips instead adjust in price principal amount in order to maintain their real value. So understanding Treasury inflation protected securities. So the principal value of tips rises as inflation rises. So inflation is the pace at which prices increase through the US economy as measured by the consumer price index. We're trying to measure the purchasing power of the dollar. Inflation becomes an issue when there isn't a commiserate rise in real wage growth to offset the negative effects of rising prices. So if you think about a place of inflation, you're going to say, okay, now it's costing more for me to purchase stuff in order for me to compensate with that. I need to have a rise in the real wages growth in order to be able to be in the same standard of living to at least meet the rising of the inflation. The cost of it is to buy the same stuff. So tips are a popular asset for both protecting portfolios from inflation as well as profiting from it because they pay interest every six months based on a fixed rate determined at the bonds auction. So that's similar to a lot of types of bonds where basically you're loaning the money in essence to the government. You're going to get the money back. It's kind of like renting like a piece of property for example. And you're going to get the rent on it, which is basically interest when you're thinking about renting money. And then you're going to get the principal back, which would be like kind of given the apartment back, for example, in a rental situation, getting the money back. You're the one that is renting the money, loaning the money in essence. So however, the interest payment amounts can vary since the rate is applied to the adjusted principal or value of the bond. So now we've got a situation where again, it's not quite fixed because you have the tips being inflation protected. So it's going to have this adjustment to it instead of being a completely fixed income kind of situation or fixed return. If the principal amount is adjusted higher over time due to rising prices, the interest rate will be multiplied by the increased principal amount as a result. Investors receive higher interest or coupon payments as inflation rises. Conversely, investors will receive a lower interest payments if deflation occurs. So if inflation being the opposite of inflation, you would think that be less likely to happen because the government typically thinks that deflation is not good. So they try to shoot and overshoot the money supplied to have the inflation be at a very at a low level between like zero and 3%. But again, they could it could fluctuate because they get it wrong and they could get it wrong because they'll get it wrong. So tips are issued with maturities of 5, 10 and 30 years and are considered a low risk investment because the U.S. government backs them. So like with other types of investments that are government backed, you would expect it to be low risk because the government's not going to go out of business. You would think if they were to default on their debts, that would be very bad. Look for the for the government. They got a printing press. So you think they'd be able to meet their obligations at maturity. Tips return the adjusted principal or the original principal, whichever is greater. Tips can be purchased directly from the government through the treasury direct system and $100 increments with a minimum investment of $100 and are available with 5, 10 and 30 year maturities. Some investors prefer to get tips through a tips mutual fund or exchange traded ETF. So notice when you think about some of these instruments, you might you might try to get exposure to them with a tool such as like an ETF. So purchasing tips directly, however, allows investors to avoid the management fees associated with mutual funds. Tips price relationship to inflation tips are important since they help combat inflation risk that erodes the yield of fixed rate bonds. So notice if you have the fixed rate bonds, inflation, you know, you got to account for basically inflation as you account for your investments. Whereas these are supposed to adjust with regards to inflation. Inflation risk is an issue because the interest rate paid on most bonds is fixed for the life of the bond. So most bonds, you have a fixed rate that you basically agreed upon. So as a result, the bonds interest payment might not keep up with inflation. So if inflation starts to get out of control, you didn't predict what was going to happen with inflation, then a fixed rate bond is going to is going to cause you more problems possibly. So for example, if prices rise by 3% and an investor bond pays 2%, the investor has a net loss in real terms. Again, that doesn't necessarily mean it's a bad thing per se. I mean, you'd like to be earning a return on it, but sometimes, of course, you're investing in the fixed income, something like bonds as a safeguard against possibly the market going down, for example. So if you had your money, say in equities and stocks and there's a downturn, the market goes down, it's possible that you're going to actually lose money, right? And not just, you know, actual dollars going down, not just the value of the dollar going down, whereas if you had hedged that, some of that in bonds, you may still be losing money given the fact of the purchasing power of the dollars, but you're not actually losing the dollars. The dollars are going down in purchasing power more than you're earning on them, but there's still kind of a hedge against like stocks going down, for example. But tips are designed to protect investors from the adverse effects of rising prices over the life of the bond. So the power value principle increases with inflation and decreases with deflation as measured by the CPI consumer price index. So that's what they use to try to figure out inflation. Inflation is not a perfect number that we can calculate. You know, they're just trying to guess, you know, what is the purchasing power by the market basis doing the CPI calculation? When tips mature, bondholders are paid the inflation adjusted principle or a rental principle, whichever is greater. Suppose an investor owns $1,000 in tips at the end of the year with a coupon rate that's the interest basically of 1%. If there is no inflation as measured by the CPI, so they got this consumer price index, no inflation, the investor will receive $10 in coupon payments for that year. So if inflation rises by 2%, however, the $1,000 principle will be adjusted upward by 2% to $1,000, $1,020. The coupon rate will remain the same. It's still 1%, but it will be multiplied by the adjusted principle amount of $1,020 to arrive at an interest payment of $10 and 20 cents for the year. So as you can see, it's increased and it's not fixed. So conversely, if inflation was negative, known as deflation, that shouldn't happen too often. That's a weird situation, but it could happen. So with prices falling 5%, the principle would be adjusted downward to $9.50. The resulting interest payment would be $9.50 over the year. However, at maturity, the investor would receive no less than the principal amount invested of $1,000 or an adjusted higher principle if applicable. So the interest payment during the life of the bond are subject to being canceled based on lower principal amount and the event of deflation. But the investor is never at risk of losing the original principle if held to maturity. So if you rent something out, you should get the original back at the end. Just like if you rent the apartment back, you should get it back. So if investors sell tips before maturity in the secondary market, they might receive less than the initial principle. So remember, when you're dealing with bonds, if you buy it from the primary market, that means you're buying it from the issuer, in this case, the government, but you could then take that and sell it on the secondary market, meaning now you're selling it to an investor to investor situation or you could buy it on the secondary market and then you could have gains and losses related to the selling of it on the secondary market. So advantages and disadvantages of tips due to the ability to increase the principal along with inflation, the interest rate returned to investors is lower than would be available for a fixed income securities. The interest paid increases with an adjustment to the principal that these investments are nearly risk free as the US government backs the debt and the investor will receive the full price invested returned when the tip matures. The semiannual inflation adjustments of a tips bond are considered taxable income by the IRS, even though investors won't see that money until they sell the bond or it reaches maturity. Some investors hold tips in tax deferred retirement accounts to avoid tax complications. However, it's important that investors contact a tax professional to discuss any any potential tax ramifications of investing in tips. Tips usually pay lower interest rates than other government or corporate securities, so they are not necessarily optimal for income investors. So obviously when you're when you have something that's going to be backed by the US government, you would you would expect less risk. So you would think the government can then issue those bonds and pay less income on that given to given the high level of security and the fact that you've got this cover against, you know, inflation to some degree would also mean that there's less risk to you and therefore you and therefore you would think that that it would be you'd have a lesser of a return right on that as well because you're taking on less risk in general. So their advantage is mainly inflation protection, but if inflation is minimal or nonexistent, their utility decreases. So if the Fed was doing their job and basically being able to keep the inflation steady and the market was able to predict what's happening in the future, then you would think that people would feel secure, possibly investing, you know, elsewhere. It's when people say, oh, inflation, if you feel like inflation is going to spike, the Fed gets out of control and there's a lot more volatility or potential risk, then you might put your money into tips, even though the return might be lower because you're thinking that you want a safeguard against this volatility that could happen in a perfect world. You would think that the feds got it figured out. They got it locked down. They're not going to have these big spikes in inflation, but every time we think that every every 10 years or so, we realize we're not so smart and something happens. So in any case, another risk associated with tips is the previously mentioned potential for a higher tax bill. So pros, the principal increase with inflation, meaning that at maturity, bondholders are paid the inflation adjusted principle. Investors will never be paid less than their original principle when tips mature interest payments increase as inflation increases since the rate is calculated based on the adjusted principal balance. The cons interest rate offered is usually lower than most fixed income bonds that do not have an inflation adjustment because you're taking on less, you're taking on less risk. So you would think that you'd get a lesser return generally, but you're safeguarded to some degree. That's the trade off. Investors might be subject to higher taxes on increased coupon payments. If inflation does not materialize while tips are held, the utility of holding tips decreases. So obviously it's kind of an insurance thing. You're kind of buying tips, most likely in the event that inflation happens. So if it doesn't happen, then yeah, you could have put your, but you're, you're diversifying to put your money in the tips. If you put your money in the tips and inflation spikes, then that's the thing that you're trying to guard against. So example of tips below is a comparison of the 10 year tips as compared to the 10 year treasury note, both issued in auction by the US Treasury Department. So treasury note, T notes are intermediate term bonds maturing in two, three, five, seven or 10 years. We discussed them in a prior presentation. They provide semi-annual interest payments. So they're going to give you payments kind of like rent payments, but instead of monthly semi-annually twice a year at fixed coupons rates, the interest rate in essence. So as a historical example, on March 29th, 2019, the 10 year tips was auctioned with an interest rate of 0.875%. On the other hand, the 10 year treasury note was auctioned on March 15th, 2019, with an interest rate of 2.625% per year. So we can see that the 10 year note pays more interest, meaning the investor will receive higher coupon payments from the 10 year note as compared to the tips investment. However, if inflation rises, the principle on the tips will increase, allowing for the coupon payments to rise while the 10 year note is fixed for the life of the bond. So you're not going to have any change on the note. So although tips protect against inflation, the offset is typically a lower yield, basically return than bonds with similar maturities. So how can I buy treasury tips? You can buy tips directly from the US Treasury Department Treasury Direct website with a minimum purchase of $100. You can also typically buy them through your broker. There are also several mutual funds and ETFs that invest in tips and other inflation linked securities that you can buy and sell like ordinary shares of stock. Can I buy tips for my IRA? Yes, you can include tips and funds that hold tips in an individual retirement account. That's an IRA, basically an umbrella that you're investing over the investment of the tips, which means you're kind of restricted to taking the money out, but possibly getting, of course, tax benefits to put them under that kind of umbrella. However, you cannot use the Treasury Direct slivers to buy them directly in an IRA. So you got to make sure that you're managing how you're going to get them in the format of your retirement account, your IRA. Instead, you would need to rely on the broker holding your retirement account. So what yield do tips have? Often the yields on tips are negative. This is because after taking into account the effects of inflation, the real yield is negative. For instance, if standard two-year Treasury yield one percent, but inflation is two percent, then the real yield is negative one percent. Tips are meant to keep up with inflation, not beat inflation. Thus, you can have a normal yield on tips that is positive, but a real yield that is effectively zero. Note that while the yield on tips may be negative, their principal value will increase with inflation, which can generate capital gains. So why does the Treasury issue tips? Tips first appeared in 1997, and the official reason for their appearance is that there was strong demand from the investing public for inflation-linked government securities. So some economists, however, have been puzzled by the government's continued issuance of tips since they amount to a more expensive way to borrow than traditional Treasuries. So what maturities do Treasury tips come in? The original tips were set at 20-year maturity. In 2009, 20-year tips were discounted in favor of 30-year tips. The U.S. Treasury presently issues five-year, 10-year, and 30-year tips.