How about those TIPS and nominals?
Don’t know what that means? You’re forgiven. You have to be an inflation worrywart to think about these sorts of things.
In a nutshell, this refers to a quick way to see what investors think about the risk of inflation, and right now it says they’re not too worried.
Still, the dangers of inflation should play a leading role in any long-term financial plan, because small-sounding numbers have big consequences.
TIPS are Treasury Inflation-Protected Securities, a form of U.S. government bond designed to protect investors from inflation. Every six months, a sum is added to the TIPS principal to equal inflation. If you spent $100 and inflation was 3%, your bond would be worth $103 after 12 months. The interest rate, or yield, is fixed for the bond’s life, but interest earnings rise because the yield is applied to the growing principal.
Nominals refers to ordinary Treasury securities. They pay a fixed yield against a principal, or face value, which does not change.
Comparing the yields on 10-year TIPS with those on 10-year nominals shows what investors expect inflation to be during the next decade. Currently, 10-year TIPS yield about 1.67%, which means you would earn that much on top of the inflation rate. Meanwhile, 10-year nominal Treasuries yield about 3.44%
The difference suggests investors expect inflation to average around 1.77%, lower than its long-term average of around 3%.
Unfortunately, the overall inflation rate, measured by the consumer price index, doesn’t really reflect any one individual’s rise in cost of living, because it is based on prices for thousands of items and no one buys them all. If you face a lot of out-of-pocket medical expenses or tuition at a private college, your cost of living may well rise faster than overall inflation rate.
Since it’s not possible to know how much your own cost of living will go up, it makes sense to build a buffer into your long-term plans.
Most financial calculators default to a 3% inflation rate. Even though many economists expect inflation to be lower than that during the next few years, it is prudent to assume 3%, or even 4%, rather than 2%.
The Savings, Taxes and Inflation Calculator shows that an investor saving $200 a month at a 6% return would have about $91,000 after 20 years, assuming no taxes.
If inflation averaged 2%, that nest egg would be buy what $61,000 buys today. At 4% inflation, it would be worth only $41,600.
Inflation hurts stocks in the short run by raising costs and reducing the real value of every dollar in corporate earnings. But companies adjust by raising prices. In the long run, stocks tend to provide a pretty strong hedge against inflation, because returns beat the inflation rate by 6 or 7 percentage points.
Ordinary bonds like nominal Treasuries can be hurt very badly as inflation chews away at fixed yields. If inflation jumped to 4% today, the current 10-year Treasury (paying 3.44%) would be losing money. Also, its market value would fall because investors would prefer newer bonds with higher yields.
Although TIPS are not especially generous, paying just 1.67% over the inflation rate, they do offer a guarantee against loss no matter how high the inflation rate goes. To get that guarantee, you have to plan on holding your bond until it matures and the government pays you all the accumulated principal. Prior to maturity, TIPS prices can fluctuate as market conditions change. TIPS can be purchased directly from the U.S. Treasury.
There also are a number of mutual funds that contain TIPS. Morningstar Inc. (Stock Quote: MORN) recommends Harbor Real Return Fund Stock Quote: HARRX) and Vanguard Inflation-Protected Securities Fund (Stock Quote: VIPSX).
—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.