The Fed is finally taking aggressive action to fight inflation, but will it work? Where’s the stock market headed? Who knows?
Real estate might be a good inflation hedge, but it’s a non-liquid asset and no sure thing. Clearly, this is not a great environment for investors or retirement savers.
If you are thinking of investing conservatively but in a way that also offers some inflation protection, here’s an option to consider.
Treasury Inflation-Protected Securities
U.S. Treasury Inflation-Protected Securities (TIPS) are a special variety of Treasury bonds that are adjusted for inflation.
Specifically, in times of inflation, TIPS principal balances are adjusted upward twice a year, based on changes in the Consumer Price Index. In contrast, significant inflation can punish the conservative investment strategy.
Okay, sounds interesting. How do TIPS work?
TIPS are sold at original issuance with terms to maturity of five, 10, and 30 years. They pay cash interest twice a year at a fixed rate that’s set at issuance.
Also, as we mentioned above, during times of inflation, TIPS principal balances are adjusted upward twice a year.
You receive the following if you hold a TIPS bond:
- Cash interest payments twice a year at the stated fixed rate. Each semiannual payment equals half the stated rate times the inflation-adjusted principal balance at the time of the payment. So, cash interest payments go up with inflation because they are based on the increasing inflation-adjusted principal balance.
- At the date of maturity, you receive the inflation-adjusted principal balance.
On July 15, 2022, you invest $200,000 in an original-issue, five-year TIPS bond with a face value of $200,000 that pays a fixed annual interest rate of 0.5 percent. If inflation over the next six months is 7 percent, the inflation-adjusted principal balance is increased by $7,000 to $207,000 ($200,000 x (7 percent ÷ 2)), and you will receive a $518 interest payment in cash for that six-month period ($207,000 x 0.5 percent x 0.5 = $518).
If the inflation rate for the following six months is 6 percent, the inflation-adjusted principal balance is increased to $213,210 ($207,000 x 1.03), and you will receive a $533 cash interest payment for that six-month period ($213,210 x 0.5 percent x 0.5).
If inflation then runs at exactly 4 percent for every six-month period for the following four years, your interest payments will increase based on the inflation-adjusted principal balance for each six-month period. You will receive $249,809 at maturity on July 15, 2027 ($213,210 x 1.02 to the eighth power = $249,809).
The Deflation Scenario
While deflation might seem highly unlikely at the moment, nothing is certain these days. Right?
During periods of deflation, TIPS principal balances are adjusted downward twice a year. The twice-yearly interest payments are also adjusted downward—because they are based on a declining adjusted principal balance. The stated fixed interest rate itself doesn’t change.
But even in the worst-case scenario of significant deflation during your ownership period, the results of owning a TIPS bond won’t be catastrophically bad, as long as you hold the bond to maturity. That’s because you’re guaranteed to receive at least the face value of the bond at maturity, even if the adjusted principal balance has fallen below that number. If the inflation-adjusted principal balance exceeds the face value, you’ll receive the larger inflation-adjusted number.
Best Way to Invest in TIPS
You can purchase TIPS upon original issue directly from the government, through the online TreasuryDirect program. If you invest this way, your principal is never at risk.
The TreasuryDirect option is available only for TIPS purchased for taxable accounts. You cannot use a tax-favored retirement account, such as an IRA, to buy TIPS upon original issue via TreasuryDirect.
If you buy a newly issued TIPS bond via TreasuryDirect, you’ll receive at least the face value of the bond if you hold it to maturity, even if there’s significant deflation. In other words, if you buy $100,000 of bonds via TreasuryDirect and hold them to maturity, then you receive no less than $100,000. Your principal is never at risk.
TIPS Tax Considerations
Cash interest payments from TIPS and non-cash increases in the principal of TIPS are subject to federal tax at ordinary income rates, but exempt from state and local income taxes.
TreasuryDirect reports the TIPS amounts subject to the federal income tax on two information forms:
- Form 1099-INT shows the sum of the semiannual cash interest payments made to you in a given year.
- Form 1099-OID shows the amount by which your TIPS principal amount increased or decreased due to inflation.