So how do you protect yourself against the impact of potential inflation? The best direct inflation hedge for US investors is the Treasury Inflation Protected Bond or TIP. This is a US Treasury bond that will go up in value with the Consumer Price Index.
Here's an example. Let's assume the CPI climbs to 5% a few years from now. If you own a TIP bond, the principal value of the bond will increase by 5% that year. And the interest payment you receive on the bond will be applied to that larger principal value. That means you have an asset that has gone up in value with the CPI and you received an increase in your income equal to the increase in the CPI. It's similar to getting an inflation adjusted raise at work.
This all sounds great, and at first blush it looks like TIPS would be the best investment for retirees. But you have to really understand how TIPS work to figure out if they will offer you much protection in this current environment.
The first thing to understand is how the increase in the principal value of the bond works. While the principal value will go up if the CPI increases, you don't really have access to that increase until you receive your adjusted principal value at maturity. Essentially, the CPI increase is added to the value of the bond, and when it matures, the US Treasury pays you that increase.
- While you could sell the bond before it matures and try to capture some of that CPI increase, that may not work out as you expect. TIPS are tricky because they have multiple moving parts. The bond value will adjust for the CPI, but the market will also make adjustments to the bond value to accomodate interest rate changes between the time you bought the bond and the time you might want to sell it. That means a rise in interest rates could push the value of the bond down more than the CPI has pushed it up.
- And then there is one other odd fact about TIPS. The increase in the CPI adjustment each year is taxable to you, even though you don't really get the money. Thus, if you hold TIPS outside of an IRA or qualified retirement plan, you will owe tax on "phantom" income.
If inflation were to stay low, say in the 2% range, the TIPS won't generate much spending power. Remember, the CPI adjustment is applied to the bond value, and then your interest rate is applied to the adjusted bond value.
Here's a simplified example of how it works. Assume you put $100,000 into a 10 year TIP bond. You would receive about $1,000 of interest for the year. If inflation next year is 2%, that means the bond value goes to $102,000 (a 2% increase) and the 1% interest rate is applied to that $102,000, for a whopping $1,020 of interest next year. Even with the adjustment, the yield on your $100,000 investment is still only 1.02%. Again, it's tough to live on that.
Now let's assume inflation jumped to 7% every year for the next 10 years. Your $100,000 of TIP bonds would increase by 7% each year to keep pace with inflation. That means you'd have an adjusted maturity value of about $197,000 at the end of 10 years. But your income would have grown to only about $1,850 in the last year of the bond, which is still less than a 2% yield on your original $100,000 investment.
As inflation was rising over those 10 years, you still didn't have much income to spend. And the challenge today is that you have no idea what inflation will be over the next 10 years. If it's low, you could get stuck with a pile of TIPS that don't produce much income; and if it's high, TIPS will help, but not until many years down the road when you receive your adjusted principal value at maturity.
Bottom line. TIPS are a very good inflation hedge if you simply want to hedge the value of your portfolio over say a 10 year period. But if you need to live off your money, because of today's low rates, TIPS may not be the silver bullet investment for retirees.
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Above material does not constitute investment or financial advice; consult your individual financial advisor prior to making any financial decision.