There are two reasons to own fixed-income securities: safety and income.
Today, yields are so low you might as well forget about income. But safety is always appealing, so it’s worth taking a look at TIPS, a type of U.S. government bond called a Treasury Inflation-Protected Security. Investors have been gobbling them up so fast the government has started issuing more, pushing the value of this market over $600 billion for the first time.
TIPS do have some downsides, but they offer a chance to conquer one of the biggest dangers to fixed-income investors — inflation. Today you could earn just more than 2% on a federally insured five-year certificate of deposit, according to the BankingMyWay.com survey, and your principal would be completely safe. But with inflation recently around 1.8%, you’d be earning almost nothing. And if inflation rose during the next five years, as seems likely given the economic recovery, you could lose money.
TIPS are designed to avert this problem by providing a yield guaranteed to exceed the inflation rate. Every six months, the value, or principal, of a TIPS bond is increased to reflect the past six months’ inflation. The coupon rate, or fixed interest rate paid by the bond, is applied against this ever-growing principal.
Currently, a 10-year TIPS yields about 1.3%. If inflation continued at about 2%, this bond would earn the equivalent of 3.3%. You could do a tad better with an ordinary 10-year Treasury bond, now yielding about 3.7%. But if inflation jumped to 5%, the ordinary bond would still pay 3.7% while the TIPS would earn 6.3%.
Like most bonds, TIPS are bought and sold in the secondary market after they are issued, and their prices and yields fluctuate according to supply and demand. If prevailing interest rates rise, investors won’t offer full price for older TIPS with lower yields, so the investor can lose money on a price decline. This may be partially offset by the semi-annual principal adjustments, since inflation and interest rates tend to rise together.