TIPS have suddenly taken center stage for investors, as soaring inflation has sparked new interest in Treasury inflation-protected securities.
But what do investors really know about these stocks, other than their catchy name?
Yes, TIPS can have a role to play in many portfolios, say investment professionals. But some investors who take the plunge with TIPS might find they’re more convoluted than conventional bonds: their value is harder to measure and there are daunting tax ripples. Rising interest rates may affect their valuation. And recent declines in TIPS auction prices, along with other market signals, suggest that some investors believe inflation may ease, which could also hurt their returns.
With all that in mind, we answer some frequently asked questions about TIPS:
What are TIPs?
Simply put, TIPS are debt securities designed to increase in value as consumer prices rise. They are issued with maturities of 5, 10 and 30 years.
Introduced in 1997, TIPS remained largely ignored in the investment universe for years as inflation remained subdued. But last year, inflation rose from an annual rate of 1.4% in January to 7% in December. TIPS fund assets have surged and have now nearly doubled since 2018 to around $295 billion.
Last year, TIPS-focused mutual funds and exchange-traded funds outperformed other bond funds for the second year in a row, with total returns averaging 5.5% in 2021, from minus 1, 7% for a US bond index fund, according to Morningstar Inc.
How exactly do they work?
Most bonds pay investors a fixed amount of interest semi-annually and then pay the original face value of the bond at maturity. TIPS are different in several ways. Their principal, or face value, rises when the consumer price index for urban consumers rises and falls in the historically rare cases where the price index actually falls rather than rising at a slower rate. But they repay at least their original face value at maturity. They pay fixed interest ratebut interest payments vary as they are based on the fluctuating face value of the securities.
Although increases in the face value of securities increase the dollar amount of their semi-annual interest payments, there are tax consequences. Holders must pay federal taxes (but not state and local taxes) on any increase in the face value of TIPS, even though they will not receive this additional face value until the security matures or they sell it.
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This means that TIPS can be a waste of cash unless they are held in a tax-free account like an Individual Retirement Account or 401(k). “The complex tax treatment blurs the inflation protection of TIPS,” says John Cochrane, an economist at Stanford University’s Hoover Institution.
An alternative to TIPS that comes without this tax wrinkle is Treasury Series I Savings Bonds, which also accrue CPI-related gains but are not taxed on those gains until maturity or redemption. . But investors can typically only buy $10,000 of Series I bonds per year. (More on savings bonds.)
How many TIPS should average investors hold?
For recent retirees, one criterion is the holdings of the 10 largest target date mutual funds in 2020. Eight of these funds hold 5-10% of their assets in TIPS. For those more retired, the largest 2010 maturity funds hold up to 18% of their assets in TIPS.
The late David Swensen, longtime Yale endowment manager, published a book for ordinary investors in 2005 that recommended that they hold 15% of their assets – half of their fixed income portfolio – in TIPS.
But mid-career investors, who often hold more stocks than those nearing retirement or already retired, may need smaller amounts of TIPS in their portfolio, if at all. Stocks tend to outperform long-term bonds and can be a better hedge against inflation. And the wages of young investors can increase with inflation, thus increasing their contribution to the nest egg.
What about TIPS funds?
Investors can avoid paying taxes on unrealized increases in the face value of TIPS by investing in mutual funds or ETFs. These funds typically pay cash dividends reflecting both the interest earned on the TIPS they hold and the increase in their face value. To do this, they use new cash inflows or proceeds from bonds sold or maturing. Investors still have to pay taxes on dividends, but not before they have benefited from increases in face value.
Although interest rates on new TIPS are only 0.125%, TIPS funds paid an average cash return of 4.5% in 2021, triple the level paid in 2020, according to Morningstar.
But opting for mutual funds also exposes investors to interest rate risk, meaning the value of funds can be affected when rates rise and bond prices fall. This has already happened in the last three months; 10-year Treasury bond rates rose to 1.930% from 1.431% in early November. During this period, TIPS funds generated a negative return of 2.6% on average, according to Morningstar.
What if you bought TIPS directly?
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Investors can mitigate this interest rate risk by buying TIPS themselves, either directly from the Treasury or in the market, and holding them until maturity. But no matter how long an investor holds them, tracking the market value of individual TIPS can be more difficult than tracking the price of a fund.
AT TreasuryDirect.gov, where TIPS can be purchased in monthly auctions with funds from a linked bank account, the updated value of the securities after the auction can only be measured with a one-by-one data search for each note or bond and some difficult calculations. And these results do not take into account changes in the market price of securities. Securities also cannot be sold prior to maturity at TreasuryDirect; instead, they must first be transferred to a bank or brokerage account via a postal paper form, a process that takes weeks.
For these reasons, it makes more sense to buy at auction in a brokerage account, which can also track day-to-day market prices for securities. Ditto for buying TIPS on the market after the auction, due to the complexity of their valuations. Morningstar Bond Research Strategist Eric Jacobson says, “Understanding their price can be a nightmare when you go to buy them yourself.
What is the price of TIPS?
The main starting value of TIPS changes daily according to the CPI. In auctions since inflation rose, new issues sold at premiums as high as 12.4% for the 10-year note in July last year. In the five years to 2020, with moderate inflation and higher interest rates, premiums for new 10-year TIPS never exceeded 1%.
These higher auction prices in 2021 have resulted in higher “break-even rates” for future inflation; according to Tipswatch.com.
But since the Fed signaled it would crack down on inflation by raising interest rates, auction premiums and breakeven rates have fallen. At last month’s auction, the premium for a new 10-year TIPS fell to 7.1%, from a clearing rate of 2.37%. Tipswatch.com blogger Dave Enna sees this as a sign that investors think the Fed will “suppress soaring inflation.”
What do the bond fund pros think?
Some large bond funds have increased their exposure to TIPS. The $79.6 billion
Bond Fund of America (ABNDX), the fourth-largest actively managed bond mutual fund, increased its TIPS percentage to 11% from 1.6% in 2021, based on a view that “inflation would be more persistent than market expectations,” says bond manager Ritchie Tuazon of Capital Group, the fund’s limited partner.
But Ryan Swift, a bond strategist at BCA Research, says he thinks TIPS are overvalued in the short term because the breakeven inflation rates embedded in TIPS are high; he expects equilibrium rates and TIPS prices to decline as inflation moderates over the rest of the year. Other assets, such as stocks or commodities, could outperform TIPS, he says, adding that even cash will outperform TIPS as interest rates rise.
Jeff Johnson, head of fixed income product management at Vanguard Group, which manages the two largest TIPS mutual funds, cautions against hoarding such funds now. Vanguard expects inflation to slow later this year and interest rates to rise, so investors shouldn’t expect recent returns to persist, he says. At current TIPS prices, inflation would need to exceed 2.41% over the next decade for 10-year TIPS to outperform conventional Treasury debt, he says.
Some experts compare holding TIPS to an inflation insurance policy, but without full protection. But at this point, Mr Johnson says: “It is like taking out flood insurance after a flood.
Mr. Smith, a former financial reporter for the Wall Street Journal, is a writer in New York. He can be contacted at [email protected]
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