Twin Cities Business, Personal Finance,
June 2007, By Jeff Dekko
A tip about TIPS: they’re not as simple as
they seem. But with oil prices still above $50
– a significant factor driving up prices on
many goods and services – it’s worth knowing
what they are and how they work because they
can serve a useful purpose for investors looking
for some protection from inflation.
TIPS stands for Treasury Inflation-Protected
Securities, and they’re one of the most innovative
investments the government has given us in quite
awhile. Championed by the former Fed Chairman
Alan Greenspan, TIPS are U.S. Treasury bonds
whose value is adjusted each month based on
the Consumer Price Index.
Created in 1997, TIPS haven’t really attracted
all that much attention, in large part because
inflation until recently has been pretty well
under control. Not quite so in 2005, when inflation
got a kick in the pants by soaring oil and natural
gas prices, higher food costs and commodity
costs, resulting in a full-year rate of 3.4
percent, up from 3.3 percent in 2004. In 2006,
prices were up another 3.2 percent. Add up three
years of 3-plus percent inflation, and a person
might start noticing that things are costing
a little more than they used to.
TIPS are meant to blunt the impact of all
that. Here’s how they work: Several times a
year, the U.S. Treasury conducts a TIPS auction,
offering for sale TIPS bonds of various maturities.
Individual investors can buy these bonds on
a non-competitive basis from most banks or brokers,
or directly from the U.S. Treasury. One of the
easiest ways is right on line, through the U.S.
Department of the Treasury’s
“Treasury Direct” web site.
Like regular bonds, TIPS carry a coupon, paying
the owner interest twice a year at a fixed rate.
TIPS currently pay about 2.50 percent on the
principal value of the bond. That’s well below
the current coupon on a conventional Treasury
bond of similar maturity. But that’s where the
inflation factor comes in. The principal value
of a TIPS bond is adjusted each month based
on the Consumer Price Index (CPI), increasing
with inflation (or decreasing with lower inflation).
When a TIPS matures or when it is cashed in,
the investor is paid the adjusted principal
or the original principal, whichever is greater.
“TIPS represent one of the purest forms of
inflation hedges there is,” said Wan-Chong Kung,
who manages several U.S. government bond funds
for US Bancorp’s First American Fund family.
“Traditionally, investors have looked toward
hard assets, such as real estate and commodities,
and to a lesser extent, stocks. But TIPS tend
to have a better correlation with inflation
than most of those other assets.”
Kung counsels investors to look at TIPS from
two points of view: tactical and strategic.
From a tactical, or cyclical, basis, she said,
TIPS are, indeed, a good way to address financial
goals that are sensitive to inflation: saving
for a college education, for example, or for
retirement in the not-too-distant future. Strategically
– from the point of view of an overall portfolio
– TIPS can help to diversify a portfolio.
“TIPS have compiled a track record of low
correlation of returns with other types of bonds,”
she said, “and low to negative correlations
with both domestic and international stocks.”
In other words, when one investment has a low
or a negative correlation to another, it means
the two don’t move in the same direction at
once. This is a good thing – especially when
one of those investments is going down in value.
But no investment is perfect, and
no investment is perfect for everybody.
In the first category, while TIPS are designed
as a hedge against inflation, they’re also bonds,
cautions Kung. As such, TIPS’ principal value
can move lower when rates rise. To the degree,
however, that the upward move in rates is driven
by higher inflation or inflation fears, the
inflation adjustment on TIPS mitigates against
the loss in principal value. Also, like other
bonds, TIPS are subject to market volatility.
The longer the maturity of a bond, the more
its price can vary with changes in interest
rates.
On an individual basis, TIPS have to fit into
your tolerance for risk, your total portfolio
composition, your investment objectives and
your time horizon, among other things. So once
again, nothing’s simple – even inflation.
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