Whenever the stock market enters a turbulent period, people look for alternatives to equities. Inevitably the term “TIPS” comes up (Treasury Inflation-Protected Securities). This is the “go-to” bond people buy that is protected against inflation. But what are inflation protected bonds and are they a smart investment?
What are inflation protected bonds?
To understand inflation protected bonds, you first must understand how bonds work. With the typical bond, the interest you receive (the coupon rate) is fixed and the market value of the bonds fluctuates based on current market interest. If inflation heats up and drives up market interest rates, the values of existing bonds generally decline. Inflation protected bonds are very different.
With TIPS, the coupon rate is fixed but the issuer (the U.S. Treasury) adjusts the value of the bonds to increase if rates rise as reflected by the Consumer Price Index. This in effect provides investors with a greater return to compensate them should inflation heat up. Get that? It’s exactly the opposite of your typical bond. Rather interesting. You can buy 5, 10, or 30 year maturities. Investors receive interest payments every 6 months.
Two Problems with These Inflation Protected Securities
1. Crystal Ball Syndrome
Nobody knows when interest rates are going to rise. Sure the people who are predicting an increase in inflation are smart. But there are plenty of clever folks who predict that interest rates will remain very low in the future as well. As a matter of fact, some pundits see a very long period of low rates. Who’s right? How do you know? The current 10-year TIPS yield is .25%. Does that really sound attractive to you?
As the fear of inflation and financial instability increases, the market demand for Treasury bonds has increased. That has driven the price up (and that’s the reason why rates are laughably low). As long as investors continue to fear an uncertain future, the prices of TIPS will remain very high. That will make it tough for you to make any money on these investments right now.
Better Alternatives for Investors
If you are looking for a way to create safe income, I believe the only way to do this is to have an extremely long time-horizon. With inflation protected bonds, the rates are too low to even consider.
Think about this. If you are looking for income, you probably want that income to last 10, 20, and 30 years or longer. If that is true, the best question to ask is how to create the most income over that time period safely. And the answer to that question is to include some equities in your portfolio.
Such an approach won’t provide any guarantees and you’ll have plenty of turbulent markets to weather. (You can take steps to potentially reduce market fluctuation in your equity portfolio but you can never eliminate the risk that you could lose money).
But over a very-long time period, the equity approach is far better for those investors looking for safe retirement income. How are you investing to create income? Are you buying TIPS or other inflation protected bonds? Why or why not?