last article on Treasury Inflation Protected Securities, or TIPS, prompted a number of inquiries. Readers questioned both the mechanics of these investments and the advice I offered about them.
So, I thought it would be a good idea to look at TIPS in a bit more detail and explain why I think they're not the best investment right now.
What are the risks of investing in TIPS?
When you buy
bond, you take on several kinds of risk. For one, there is the "default risk" -- the risk that the borrower to whom you're lending money may not, after all, repay you. In the case of TIPS, the borrower is the U.S. Treasury. The risk of default is minimal or nil. There could, however, be a measure of default risk in some TIPS funds if the bonds of borrowers other then the Treasury are included, which is sometimes the case.
There is also "interest rate risk." That is the risk of buying a bond today and locking into a fixed interest rate of, say, 3.5% per annum, only to find that the same borrower, because of the current rising interest rate environment, is willing to pay 4.5% on the same type of bond it issues next year. That would make your bond less attractive and less valuable.
In other words, you could end up selling a TIPS investment for less than you actually paid for it.
How can bonds that pay a fixed amount of interest and are periodically adjusted for inflation ever lose money?
If you buy a TIPS position and hold it to maturity, you might lose the opportunity to earn higher interest if future rates rise, but you will probably not lose principal. If, however, you sell a TIPS position before maturity, or if deflation
flation occurs, you can, after all, incur a loss. Let's look at the mechanics.
When you invest in TIPS, the face value of the bond is adjusted for inflation by the Treasury every six months. These adjustments are called "inflation accretions." They are set by the Treasury in relation to changes in the consumer price index. When an inflation adjustment is made, you do not actually get cash. Instead, the Treasury adds the "accretion" hypothetically to your principal, and then pays you half-yearly interest on the combined amount of your face-value principal plus any accretions.
The Treasury actually pays these inflation adjustments in hard cash when the bond matures and you get your face-value principal back. That is why you should only hold TIPS in tax-sheltered accounts such as 401(k)s and IRAs. Otherwise, you will be liable for income taxes on the "accretions" when they are
tabulated, even if you only receive the actual payment years later. (But check with a tax adviser about your personal tax situation.)
Although you can theoretically invest a minimum of $1,000 in TIPS having a maturity of five, 10 or 20 years, you will often be unable to make any TIPS investment outside of a fund or ETF for less than $10,000.
TIPS are initially sold at auction, then traded among investors. And those with extremely large amounts of money to invest
meaning many millions of dollars command much better prices than individuals with only $1,000 or $10,000.
So, unless you have a large amount to invest, it often isn't cost effective to buy TIPS outside of a fund.
Even so, suppose you call your broker to invest $10,000 in a TIPS bond maturing January 15, 2011. That bond would give you a fixed rate of interest of 3.5% per annum.
These numbers, by the way, are real as of Monday's close Because of strong demand for such securities, however, you would actually have to pay $10,503.86 for the investment -- the seller's price -- so you would pay more than the face-value principal. You would also have to pay for the inflation accretions on the bond thus far -- another $1,619.28.
So, the total cost for this $10,000 face-value investment would be $12,123.14
that is the $10,503.86 price you have to pay for the bond plus the $1,619.28 inflation adjustment.
The U.S. Treasury will pay you 3.5% interest semiannually on $11,619.28
the $10,000 face value of the bond plus the $1,619.28 inflation accretion to date. But your actual outlay for the investment is $12,123.14.
Consequently, the "yield" or net return on this investment will be
than the stated 3.5%. In fact, my broker computed the net yield as 2.33% after taking compounding and buying costs into account.
So if you hold the bond to maturity, you will earn a 2.33% rate of return and have adjustments of principal for inflation. But you could still lose money in two ways.
One, if you sell the bond before its maturity, the future price of the bond could be
than the $10,503.86 you paid. That could happen if interest rates rise and future buyers are only willing to buy your bond at a discount. And two, if deflation were to take place between now and the time you sell
or the bond matures, you might not get full offset to the $1,619.28 "inflation accretion" you also paid. In other words, you could end up with a future return of capital that is
than the $12,123.14 outlay you made.
Thus depending on pricing, the direction of interest rates, and the incidence of inflation or deflation, you can, after all, lose money with TIPS.
So are TIPS a good investment or not?
TIPS are an excellent investment -- provided you have a large sum to invest, command good pricing, hold your investment to maturity and accept opportunity loss, or provided you invest in a fund that buys TIPS at attractive prices. However, bond yields in general remain rather low. If you buy into a TIPS fund today, you will probably buy into securities, many of which were bought at high prices in the past that could lose value because the market expects interest rates to rise.
Consequently, I believe investors should hold off on TIPS funds until prices and returns improve.
Jim Schlagheck is a wealth management professional who has counseled ultra-high-net-worth families, endowments and pension funds in the U.S., Europe, and the Middle East. He is a former senior executive of American Express Bank, UBS AG, Bank Julius Baer, and TAIB Bank. During his career, Schlagheck launched a family of mutual funds (now holding $4 billion), led teams of financial planners and investment advisers based in New York, Bahrain, and Geneva, Switzerland, and helped many high-profile clients to protect and enlarge their wealth. Jim has a blog on investment topics
www.invest-blog.com and is the author of "Show Me The Money!", a soon-to-be-published book that synthesizes his novel views about investing for retirement.