Inflation, inflation, inflation…that’s the word that we keep hearing over and over.
And it doesn’t take long to find someone to tell you their own experiences of dealing
with something that costs a lot more now than it did just a few months ago. And on top of
that, wow, has that word ‘inflation’ been spooking the markets. And as investors have
seen, there’s been a lot of volatility over the past few months, particularly in those
growth stocks that served them so well last year. And it seems like everyone is trying
to stay ahead of the curve looking for the best place to put their money in this newer
inflationary environment. Now some people are looking at crypto for the first time and
others are doing what many people have done in the past and that’s looking to gold.
And there’s no shortage of information out there on those options. But as you know, those
options can be volatile with some wild swings, so you definitely need to have the stomach
for 'em. Now maybe you’re at the point where you're ready to get off the roller coaster
and are looking for a less volatile option, a safer way to simply protect your money,
yet not lose its value to inflation during an uncertain time. So if that’s where you
are, today I thought I would talk about another option that maybe a lot of you hadn’t heard
of...or maybe are just starting to hear it for the first time, particularly as a newer
investor that hasn’t dealt with inflation since you started investing, because let’s
face it, it’s been awhile since inflation has really been an issue, at least in the
US. So to that point, the option I’m talking about today are US Treasury Inflation-Protected
Securities, or more commonly known by their acronym, TIPS, T-I-P-S.
But first, I want to welcome you to Healthy, Wealthy, and Wise where talking about our
financial wellness and how to achieve it is our top focus. My name is Kevin and I want
to give a shout out to everyone in the community that keeps me motivated to make these videos…and
for anyone new here, if hearing about easy, everyday things you can do to improve your
financial health is something you’re interested in, well consider this your formal invitation
to join the community…and all you have to do is hit that subscribe button and turn that
notification bell on, it’s totally free and it’ll make sure you don’t miss any
videos as soon as they come out. Now upfront, I do want you to know that I’m not a financial
advisor, and while my videos are meant to be informative, they should not be seen as
a recommendation for you to take any action based on the information or the personal opinions
I share—you should always do your own research or consult with your own financial advisor
when making any investment decision. So with that, let’s get into it…what are
TIPS?…well, simply put, they are a type of U.S. Treasury bonds that are actually indexed
to inflation, meaning as inflation goes up, the rate of return does as well. And now that
we’ve been hearing so much about inflation eroding our purchasing power, meaning that
what we can buy now for $100 dollars might cost, say $110 or more next year, this sounds
like something to consider, right? Especially now since there’s a lot of concern with
so many stock prices coming back down to earth. But before we get into how TIPS works, let’s
talk a little about bonds in general so that it’ll be easier to see what makes TIPS different
from your typical government bonds. Alright, so with a typical bond, which in
its most basic meaning is that of it being a loan from an investor to a borrower that’s
usually a company or a government, where that borrower that issues the bond includes the
terms of the loan, the interest payments that will be made, and the maturity date, which
is the time the principal borrowed will be paid back to the investor.
Now what investors in bonds are most interested in are the interest payments they earn for
loaning their money to the issuing company or government. And that rate on a specific
issuer’s bond, or what’s called the coupon rate as you might’ve heard before, is a
fixed rate whose percentage is dependent on a couple of factors. Number 1, is the credit
worthiness of the issuer...meaning how likely is the borrower to default on the loan? Which
as you know would not be a good thing! So when we think of the prime example of a safe
borrower, historically we think of the U.S. government, with their pledge not to default
on any loans. And history shows, that up to this time, the US has never defaulted on its
debt, thus making it a safe borrower. Now there’s obviously other entities out there
that are not as a safe as the US government that go along a range of credit worthiness,
from established, profitable companies to that brand new start-up that has yet to make
a dime, and therefore could be more likely to default. But the key point is, the more
creditworthy the borrower, the lower rate you’ll receive from their bond versus the
bonds issued by more risky issuers, because those companies that are at higher risk of
defaulting have to pay a higher rate to get investors to loan them money, because otherwise,
if they paid the same rate, people buying bonds would always go to the safer issuer.
Makes sense, right? So for riskier issuers to persuade investors to buy their bonds instead,
they entice them with a higher percentage. So like most things, the higher the risk,
the higher the potential reward. Now the other major factor in determining
the rate that the bond pays out is based on the time it takes for the bond to mature.
In general, all other things being equal, the longer the time it takes to mature, the
higher the rate will be since the bondholder, or the investor, is facing increased risks
of interest rates and inflation going up over that longer time period. Which makes sense…because
you don’t know what’s going to happen in the next few years with interest rates
or inflation and if you expect them to go up, then the money tied up in the bond exposes
it to losing purchasing power in the future. So if you have a bond earning 2%, but inflation
goes up to 3%, then in effect you’re losing money, because what you’re earning isn’t
keeping up with the rising costs of the goods and services you pay for.
Now, you also might know you don’t have to hold a bond all the way to maturity, meaning
you can trade it, but if it’s a $100 bond with a 2% coupon rate, and interest rates
go up to 3%, then the only way someone is going buy that bond off of you is if you sell
it at a discount, otherwise they would just buy a new bond issued at the higher rate.
Now I don’t want to get too off topic here, and if you want to hear more bonds in general,
let me know in the comments, but the issue here is if you hold bonds and inflation kicks
in, leading to interest rates rising, then your bond loses actual value if you want to
trade it before maturity. Of course you can keep it and hold it to maturity so you actually
get the face value of the bond, but then you’re also potentially talking about years where
the rate it pays you is less than inflation, so in that sense you’re still falling behind
as you lose purchasing power over time. Ok? Are you hanging in there with me?...because
this is where it gets more interesting. Alright, so thinking about where we are right
now, where the Fed has set their federal reserve rate to essentially zero, the economy is starting
to heat up, there are real, tangible signs of inflation out there... which way do you
expect interest rates to eventually go? Up, right? They almost have to. One of the biggest
tools the Fed has to tamp down inflation is by raising rates. Now the Fed is saying that
they have no plans to change their Federal Reserve rate any time soon, but when they
do, they’ll be raising it, which would negatively impact the bonds out in the market paying
low interest. But let’s say even if the Fed doesn’t raise the rates, but inflation
goes up, then the interest paid by your bond is outpaced by inflation, therefore, you are
still losing money when it comes to future purchasing power. So the biggest weakness
of a bond is the nature of its fixed rate where, when the economy is heating up, the
value of your bond, or really the money you have tied up in it, is not growing enough
to preserve your future purchasing power of that money. And of course, as I said earlier,
if rates go up, then the actual value of your bond...if you want to trade it before maturity...goes
down. Okay, that gets us back to Treasury Inflation-Protected
Securities, or again TIPS. So what TIPS do is leverage the biggest weakness of bonds
during an environment where inflation is kicking in and that is it protects against inflation.
And it how it does this is that the principal, or the amount you invest or loan the government,
is adjusted by changes in the Consumer Price Index or CPI, which is a measure of the average
change over time in the prices paid by consumers for typical goods and services. So when you
hear about reports of inflation, it’s usually based on actual increases of the Consumer
Price Index. So what TIPS does is pay interest twice a year, at a fixed rate which doesn’t
change. But because the rate is applied to the adjusted principal, when inflation is
rising as evidenced by the CPI, it leads to your principal being adjusted to a higher
amount, and then the fixed rate is multiplied to a higher amount of the principal so therefore
the amount you are paid would go up. So using some numbers for easy calculation, if your
TIPS original principal was $100 and it was paying at a rate of 2%, you multiply 100 times
2% and you would make $2 of interest. However, if inflation rises and your principal is adjusted
to $105, then you would multiply that same rate of 2%, but this time with the higher
principal of $105 which would make the interest you’re paid $2.10. And then if you hold
the TIPS to maturity, you would get the adjusted principal paid to you. So if you invested
in a $100 TIPS, and over the years it gets adjusted to $150, you would then be paid $150
once it matures. Since this concept is the most important part
of the video, let’s go over it again, in a slightly different way just to make sure
it’s making sense to you. So the relationship between TIPS and the Consumer Price Index
affects both the amount you are paid when your TIPS matures and the amount of interest
that a TIPS pays you every six months. Like your typical bond, TIPS pays interest at a
fixed rate. But because the rate is applied to a principal which can be adjusted when
the CPI changes, which again during inflation would go up, interest payments would increase
at those 6 month intervals. Now you might be thinking that, “okay I
get it, and I know it’s not likely to happen anytime soon, but let’s say something dramatic
happens over the next couple of years and we actually go into a period of deflation,
what happens then?” Well in that case, your interest payment will
decrease as your principal would be adjusted down as the CPI were to go down. Now there
is a provision that will protect you when it comes to the original principal or the
money you actually used to acquire the TIPS and that is, at the maturity of the TIPS,
you will receive either the adjusted principal or the original principal, whichever is greater.
So if deflation hits and your $100 original principal gets adjusted down to $95 over the
period you hold the TIPS, you still would have your original $100 paid back to you at
maturity, because it's the greater of the two numbers. This provision protects your
initial investment against deflation, taking some risk out of the equation, as long as
you hold it to maturity, so just keep in mind that if you trade it away before it matures,
that provision doesn’t count. So again, with inflation which is a rise in the CPI,
the principal increases and you would get that adjusted or higher amount at maturity.
With deflation, where the CPI drops, your principal decreases, but at maturity if the
adjusted principal is lower than what you originally bought the TIPS at, then you still
would get your original principal paid back to you.
Now obviously the nature of the principal being adjusted down in a deflationary period
is a negative with TIPS when compared with traditional bonds where the principal doesn’t
change nor does your interest payment. And keep in mind that, because of the adjustment
factor to the principal, TIPS usually pay lower interest rates than other government
or corporate securities at the time they’re being issued. So in periods of deflation,
you would come out better with a traditional bond versus holding a TIPS. So a lot of this
comes down to where you think inflation is going. If you think inflation will be rising,
TIPS could be a good hedge against it. However, if you think a period of deflation is on the
horizon, which is more unlikely, but has happened, then a TIPS would not be a great investment
as opposed to just holding a traditional US Treasury note or bond.
So if you consider where things are in the economy, that the signs of inflation are out
there and that you feel it could be substantial and longstanding, you might come to the conclusion
that TIPS could be a good option for you. Obviously, this is real similar to market
timing which can be hard to do, but again, if you’re looking at everything and feel
strongly about inflation coming with all of the stimulus out there, all the money being
printed, and the reopening of the economy, you just might feel strongly that you want
to invest in TIPS as part of your portfolio to help preserve your capital in a safer way,
where at the very least, the principal you invested will be protected from going down.
So if you feel that way and want to get some TIPS, you have a couple of options as to where
to get them. One is to buy them directly from the U.S. Treasury at TreasuryDirect.gov, which
is more time-intensive, but you don’t have the fees that you would get by going through
a broker, which you can also do. If you go that route, you'll see that TIPS come in terms
of 5, 10, and 30 years. Now you can also buy shares of mutual funds or exchange-traded
funds that contain diversified mixes of TIPS. In that case you’ll want to consider the
funds expense ratio fees, where all things being equal, the lower the cost, the better.
The benefit here is that you can buy into TIPS more easily, as well as get out of TIPS
easier than if you own them directly. But with a TIPS ETF or mutual fund, you are losing
one of the main advantages of buying individual TIPS which is that the investor will not lose
actual money if the bond is held to maturity as I said before; you don’t have that safety
provision when you invest in a fund. One last thing I would like to quickly add
is that there can be some tax considerations with the idea of the principal being adjusted.
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. One way investors can avoid those complications is to hold TIPS in a tax-deferred
retirement account…again, I definitely recommend you doing your own additional research or
consulting with a financial advisor before making any big financial moves.
So that’s what I have for you on TIPS…what do you think? Are they something you’re
going to consider? Or do you have another strategy to hedge against inflation? Let us
know in the comments. We’re always looking to learn from each other here.
Anyways, I hope you enjoyed the video, and if you did, please press that like button
and share with your friends and on any of your social media sites and forums you’re
on to help spread the information. And again, if you’re new to the channel or just an
occasional visitor and you found this information helpful, we’d love to have you join the
community, you just gotta press that red subscribe button…we’d love to have you onboard.
Until next time, thank you for watching…and have a great day!