How Income Investors Can Thwart Inflation with TIPS

TIPS - How Income Investors Can Thwart Inflation with TIPS

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The last few months haven’t been easy ones for income-oriented investors. With interest rates on the rise, bond values, REITs and dividend-paying stocks have all been pressured lower as a means of adjusting for the prevailing interest rates of the day. It’s one reason why Treasury Inflation-Protected Securities, or TIPS for short is worth a look.

Another reason is that, with the inflation outlook being largely uncertain there’s no end in sight to the frustration.

What’s done is done, to be clear. Though the pessimists arguably overshot with their selling of income-paying securities, any bounce-back from them is apt to be short-lived. Analysts are calling for at least three more rate hikes this year, and possibly four.

The analyst crowd is also modeling three more increases in the nation’s foundational interest rate in 2019. All of them will ultimately work against the value of income-driving securities, even if the equity sliver of them stand to benefit from the same economic growth that’s driving the inflation that’s driving interest rates higher.

If your only goal is to generate reliable income that doesn’t lose ground with inflation though, there is a solution,

They’re not without some of the other trappings of government-issued bonds. Yields are relatively tepid, since they’re basically risk-free. And, buying and selling them isn’t quite as simple as a stock trade. You’re also somewhat limited in terms of maturity lengths.

Still, for the right investor (income investors that truly do just want to generate inflation-matching income), Treasury Inflation-Protected Securities are a welcome solution to the problem inflation poses.

Getting a Handle on TIPS

By government-bond standards, the backstory on TIPS is interesting. With demand for such an option not abating, the U.S. Treasury introduced the 10-year version of them back in 1997.

Different maturity lengths have surfaced in the meantime, with 5-year and 30-year maturities also now available. They’ve all essentially worked the same though. That is, the bi-annual interest payment is reset every year to reflect increases (or decreases) in the Consumer Price Index; you know it better as “the inflation rate.”

They’re not necessarily the perfect investment they may seem to be on the surface. Deflation can also take a toll on TIPS values, and their corresponding interest payments can subsequently fall. Upon maturity though, owners are guaranteed the greater of their original principal, or an inflation-adjusted return of capital.

There’s no such guarantee for owners that choose to sell before a particular inflation-protected matures though; there’s the proverbial “catch.”

All the same, it’s a compelling case. There may be an easier way to utilize Treasury Inflation-Protected Securities, however, than by trading these bonds directly.

A Better Solution Than TIPS?

Though the ETF industry has exploded in recent years, the industry hasn’t exactly justified its existence in all cases. All too often the fund company is a mere packager of equities that offer an index-minded product to meet a need that may or may not exist.

The TIPS arena is one where it really is easier, better, and maybe even more cost effective to let a manager take care of the buying and selling. Fund companies also have the kind of capital (and time) to build a “bond ladder” that fans of bonds should be aiming for.

The biggest ETF in the game is the iShares Barclays TIPS Bond Fund (ETF) (NYSEARCA:TIP), and it’s also the most liquid. The Schwab US TIPS ETF (NYSEARCA:SCHP) and Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ:VTIP) are also big enough, and well-traded enough, to be equally-viable options.

Other TIPS funds exist, for income-seekers willing to dig a little deeper in the hunt for something very specific within the Treasury Inflation-Protected Securities.

The Final Word on Treasury Inflation-Protected Securities

Again, they’re not for everybody despite their superficial appeal. The current yield on five year TIPS is 0.69% better than our current inflation rate, to be determined at a later date.

The yield on 30-year Treasury Inflation-Protected Securities isn’t much better at 0.95% higher than the inflation rate we’re presently making. That’s not bad, but it’s entirely possible an income investor could do better using other instruments that are almost as safe.

Still, knowing inflation is on the horizon and that the Fed already has it in their heads that several more rate hikes are in the offing, Treasury Inflation-Protected Securities may be a savvy answer for the uncertain environment we’re in.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.

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