To The Moon

Photo by engin akyurt on Unsplash

Should these be in your portfolio?

Let’s get the definitions out of the way.

TIPS are Treasury Inflation-Protected Securities which have been issued by the U. S. Treasury since 1997.

IABs are Inflation-Adjusted Bonds issued by the U. S. Treasury and other countries.

TIPS were issued to protect investors against inflation.

The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Bureau of Labor Statistics Consumer Price Index for All Urban Consumers. Now it gets a little tricky. While the interest paid is usually adjusted for inflation the principal or face amount always gets adjusted. When interest rates go up more value is added to the face amount of the security and if deflation occurs they are adjusted downward (but never less than the face amount).

So, when the security matures you either get the original face amount (never less) or the adjusted value if there was only inflation, whichever is more. The investor’s original investment is protected against inflation since s/he can never get less than the original face amount.

TIPS come with 5-year, 10-year, or 30-year maturity.

As with other marketable securities you can either hold them to maturity or sell them before they mature.

IABs cast a bigger net over many different kinds of inflation-protected securities.

IABs are also known as inflation-linked bonds, inflation-indexed bonds, and just I-bonds. TIPS are the largest component of the IAB global market. Canada, India, and many other countries issue inflation adjusted bonds.

Inflation can bite into your portfolio’s performance big time.

For example, if your portfolio is returning 6% and inflation is 2% then obviously you are getting only 4% in real returns.

Inflation adjusted securities can help protect against inflation since they increase in value during inflationary periods. However, in times of deflation they do not offer very good protection.

Another think to look out for is the returns on these securities are in no way correlated with anything other than inflation. Other fixed-income assets may better fit your needs and objectives.

Of course, there is risk involved in any investment, and IABs and TIPS are no exceptions.

While TIPS have an initial floor set by the U. S. Treasury, the investor should be careful when buying older TIPS since they may sell for much more than their original face value if there were many years of inflation. If there is subsequent deflation after they are bought, there will be a decrease in their value, but of course, never less than the face amount.

Taxes must also be considered. As the face is adjusted for inflation, the increment is considered current annual income by the Internal Revenue Service. Remember the investor may get inflation-adjusted income from the interest paid, but they do not receive the adjustments to the face value. So, the tax is due on the adjusted face value but the investor will receive that adjustment when the bonds come due or when they are sold.

Investors might carefully consider adding IABs to obtain a diversified portfolio.

Historical notes: Inflation-adjusted bonds were developed in the late 1700s to help U.S. investors with inflation during the American Revolution. In 1981 the U. K. issued the first modern IABs.

$S&P 500(.SPX)$  $DJIA(.DJI)$  $NASDAQ(.IXIC)$