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Using TIPS For Added Risk Diversification

By: , dated October 26th, 2012

A lot of people have the misconception that the savings account they have at their bank represents a risk-free investment. While it is true that they needn’t worry about losing the money they have deposited in the account (assuming it is a federally-insured institution), savings accounts come with a high degree of purchasing power risk. When the inflation rate is greater than the interest rate paid on the account, the account holder loses.

Assume, for example, that you deposit $100 in a bank account that pays interest at a rate of 1% a year. At the end of the year, you will have $101 in your account. But if the inflation rate during that same year is 3%, then an item that was priced at $100 at the beginning of the year can be expected to cost $103 at year’s end. Therefore, your purchasing power will have diminished by $2 during the year. But what, if any, alternative do you have?

You could, of course, invest more in stocks. Stocks are regarded as an inflation hedge since the annual return on the stock market has exceeded the inflation rate in almost every year since 1926. But investing in stocks exposes you to a lot of other risks, which you may not want. There is a lower-risk alternative, however:  Treasury Inflation-Protected Securities (TIPS).

TIPS are bonds issued by the U.S. government and, as such, are considered as free from default risk as a savings account at a bank. They can be purchased in increments of $100. They pay interest at a fixed rate twice a year; however, the face value of the bond is adjusted in accordance with changes in the Consumer’s Price Index (CPI), and the interest payment that you receive every 6 months will be equal to one-half the stated annual interest rate times the adjusted face value of the bond. TIPS are initially issued with 5, 10, or 30 years to maturity, but they are marketable instruments, and you can buy one in the secondary (used) market with whatever maturity you desire.

To illustrate the payment schedule of a TIPS, let’s assume you purchase a TIPS in the secondary market that has a fixed annual interest rate of 4% and 18 months to maturity for its face value of $100. (A TIPS can also sell for more or less than its face value in the secondary market; we’re assuming it is currently selling for its face value for simplicity). Also assume that inflation is 2% the first 6 months, 1%, the second 6 months, and 1.5% the last six months you own the bond. The adjusted face values of the bond and your cash flows are provided in the table below:

Time Inflation in period just ended Adjusted face value Interest payment* Principal payment
Today not applicable $100 not applicable not applicable
6 months 2% $102 $2.04 not applicable
12 months 1% $103.02 $2.06 not applicable
18 months 1.5% $104.57 $2.09 $104.57

*The annual interest rate is stated to be 4% in this example.  The investor will receive half of this, or 2%, every six months.                      

 

Thus, you will receive interest payments of $2.04 and $2.06 at the end of 6 and 12 months respectively, and a final payoff of $106.66 at the end of 18 months (= $104.57 principal and $2.09 interest).

This is not to say you should close your savings account and invest all that money in TIPS instead. Unlike savings accounts, TIPS do expose the investor to interest-rate risk.  If interest rates fall, the price of a TIPS will increase, which is good news, but if interest rates increase, the price of a TIPS will fall. This is not a concern if you hold the TIPS to maturity. You will always receive at least the face value of the TIPS when it matures, even if the face value has been adjusted downward due to a period of deflation during your holding period.  But if you find yourself in need of cash before the maturity date, you may have to end up selling your TIPS for less than what you paid for it. Nevertheless, investing some of your money in TIPS will enable you to add diversification to your portfolio with a low-risk hedge against loss of purchasing power.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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