Saturday, June 25, 2011

Surviving inflation part 2: Treasury inflation protected securities

In the first article of this series I talked about why I believe investing in stocks of good companies is the best way to protect yourself from inflation. But unless stock prices are really attractive (and even then I believe investors should still maintain ample liquidity), investors should probably have a certain percentage of their portfolio invested in cash and other short-term liquid assets such as CDs and treasury bills.

While it’s prudent to hold some cash in your portfolio, the value of your cash holdings can get significantly eroded in periods of high inflation. As a way to give their cash holdings and portfolios better protection against inflation, investors can consider substituting some of their cash and cash equivalents with treasury inflation protected securities or TIPS.

TIPS pay a fixed rate of interest that’s based on the TIPS’s principal that rises with inflation. The consumer price index determines the increase in the TIPS principal.

Here’s an example: Let’s say you bought a TIPS at auction with a $1,000 face value that pays a fixed coupon of 2% on the TIPS’s principal. The consumer price index is at 10% for the first six months which will cause the treasury inflation protected security’s principal to rise by 5% or $50 when it’s adjusted at the end of the first six months (The principal only increased by $50 or 5% instead of the CPI’s 10% because the principal is adjusted on a semi-annual basis not on an annual basis). And because the coupon payments are based on the principal of the TIPS which have been adjusted to $1050, the investor would get a $10.50 coupon at the end of the first 6 months (again, the investor only received 1% in interest or half of the TIP’s 2% annual fixed interest rate as the coupon was a semi-annual coupon).

It is important to note that the TIPS’s principal can also decline with deflation. This will cause interest payments to decline as interest is fixed to the principal of the TIPS. TIPS do, however, protect the investor’s principal in the sense that the investor will receive at maturity either the adjusted principal or the face value of the TIPS, whichever is greater. This will only work if you buy TIPS at auction or on the secondary market when they’re trading at or below face value.

It is also important to note that in the US, investors are taxed on the interest payments of the TIPS as well as any increases in the principal even if the TIPS did not mature, and regardless of whether or not they sold the TIPS. That’s why it’s important to hold TIPS in tax-advantaged retirement accounts.

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio.