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Rob Williams

TIPS for Protecting Your Investments from Inflation

by Rob Williams, CFP® / July 2010 / Investment Management

Will our government's massive, potentially out-of-control spending and stimulus programs eventually lead to high inflation? Many of our clients have asked this question and want to know what BWFA will do to protect their investments against this threat.

We think these clients have asked a worthy question. Many prominent economists think our government's policies are inflationary, and a recent national poll showed that many Americans believe inflation will start to rise. Therefore, BWFA wants to describe one particular security we have added to the BWFA Buy List of securities researched and approved for purchase: Treasury Inflation Protected Securities (TIPS). TIPS are an excellent hedge if we see signs of inflation.

TIPS are bonds issued by the U.S. Treasury that have a principal value that rises or falls in line with the Consumer Price Index (CPI). For example, you can buy $1,000 of a TIPS bond today which pays a 3% annual interest rate and matures in five years. If inflation increases 22% over the next five years (that is only 4% per year), then you would receive $1,220 when the bond matures. This gives your principal investment complete protection against inflation.

Furthermore, your interest payments would grow by the inflation rate as well. In the first year, you would earn $30 per year (3% of $1,000), but if inflation was 4%, then you would earn $31.20 in the second year (3% of $1,000 times 104%). This means that your income is protected as well. The bottom line is TIPS provide excellent protection against inflation and are backed by the full faith and credit of the U.S. government.

To date, BWFA has taken only a small position in TIPS using an exchange traded fund, iShares Barclays Treasury Inflation Protected Securities Bond Fund, which holds many individual TIPS bonds with a range of maturity dates. This fund has performed reasonably well since we added it to our Buy List in May 2007. However, we are cautious about buying more at this time for the following reasons:

Inflation remains at extraordinarily low levels

Despite big government spending, the U.S. inflation rate continues to be very low because high unemployment has prevented wages from rising, and low consumer demand has kept prices down. The most recent CPI calculation released for April 2010 (excluding food and energy) found the annual inflation rate at 0.9%—its lowest rate in 44 years. This rate is so low that some economists fear deflation (declining prices) as a greater threat than inflation. BWFA correctly forecasted that inflation would not occur during the depths of this recession, and we plan to take no further action until there are signs that inflation will occur.

TIPS currently pay low interest rates

As of June 2, 2010, Treasury bonds maturing in five years had an annual yield of 1.980%. A TIP bond maturing in five years had an annual yield of only 0.289%. The difference between these two rates implies an annual inflation rate of about 1.7%, which we think is a reasonable estimate. However, BWFA thinks both of these yields are too low.

TIPS do not protect against rising interest rates

Like all bonds, the prices of TIPS bonds will go down when interest rates go up. Right now interest rates are very low. Just look at the rates you earn on money market funds or CDs. The Federal Reserve may be keeping interest rates low now in order to stimulate our economy, but eventually rates must rise. If inflation appears, the Fed will definitely raise interest rates—and the prices of all bonds, including TIPS, will go down.

To conclude, we believe that now is not the time to buy TIPS. But if our government's extraordinary economic policies eventually lead to rising prices, we are prepared to use TIPS and other strategies to protect our clients against high inflation.



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