Treasury Inflation-Protected Securities (TIPS) are a form of U.S. Treasury bonds set-up to protect investors protect against inflation. The inflation rate can be calculated in many ways, but the TIPS use the consumer price index (CPI) as a measure for inflation. Despite many shortcomings of the CPI, many investors still use TIPS to diversify and balance classic 60-40 stock-bond portfolios.
TIPS are one of the few asset classes that directly pay an investor for realized inflation, making them attractive during periods of rising inflation. This compensation is the same for all TIPS securities. For this reason, investors who believe interest rates might fall often prefer longer maturity TIPS, while those who believe that rates will rise may want shorter maturity TIPS. Like regular Treasury bonds, TIPS pay interest twice a year based on a fixed rate. The interest payed on Treasuries are based on the principal amount, however in TIPS this principle amount is adjusted for CPI. So if inflation rises, also the principal amount rises. As the coupon interest is calculated using this principal amount, also the interest payment rises accordingly.
Bonds Are Typically Low Risk
Investing in bonds is considered low risk, but there still is interest rate risk and credit risk. The most important risk is the interest rate risk, as yields are rising this could pose a problem to lower yielding Treasuries, and also TIPS. However, as these rising yields are based upon fears for inflation the TIPS provide some balance in this situation. Treasury bonds typically do not have default risk as they are backed by the US government which is not likely to default (otherwise there would be a way bigger problem than inflation). Other high risk bonds typically do have this risk and considering the likely rise in interest on corporate bonds, this could pose a big threat to the US economy.
Interest rate risk is the risk of a bond becoming less attractive due to a rise in interest rates. Investing in long term bonds, meaning that you fix your investment for a long period has higher interest rate risk. Therefore, long term bonds often offer higher premiums (or yield) than short term bonds. TIPS with shorter maturities therefore look more interesting as inflation is likely to rise coming months.
Once interest rates begin to rise, the yields on TIPS rise too. This is because rising interest rates bring down inflation. However, the hike is expected to be gradual. Therefore, on the short run it could be an idea to invest in TIPS ETF’s that are typically well-diversified and offer good yield, but also protect against inflation.
What’s Next For Stock Markets?
The Golden Investor has long warned for this kind of scenario, where rises in inflation could lead to rising yields while increasing stimulus will only do more harm. This split situation for central banks could pose a big threat to the economy and investors are realizing this. Other ways to play into the rising interest rates could be investing in financial companies that benefit from rising interest rates as it gives the opportunity to them to grab a larger piece of the pie compared to situations with low interest rates.
However, considering the current economic situation central banks will have to choose to either provide price stability and to harm employment or the boost the economy even further and to accept higher inflation. The latter has been done in the recent decade after the last financial crisis and as most money did not go to citizens but flooded housing markets, banks and stock markets this did not lead to inflation. During the current corona crisis fair governmental spending for all people has led to bulging amounts of spare cash for many still employed people. They are likely to overspend once major lockdowns around the world end, which will expose this monstrous danger that has been silenced with large monetary expansions since 2008.
In last year’s Golden Manisto The Golden Investor discussed this “Paul Volcker”-type scenario on 15 March 2020, right after the FED announced their largest monetary expansion to date. If it really is going to lead to such a scenario is not certain. However, protecting yourself against inflation is not a bad idea considering the above mentioned phenomena.
Disclaimer: The Golden Investor is not a fortune-teller, be sure to make the right decisions in accordance to your own financial situation, this is not investment advise or anything like that.