Unfortunately, inflation is back with us in a significant way. After remaining at low levels for several years, consumer prices have soared recently, led by eye-popping increases in energy.
Besides draining your bank account, inflation can make your fixed-rate investments less valuable.
Fortunately, there are ways you can give yourself a hedge against inflation—and we don’t mean by stocking up on corn flakes and tissue at your nearby warehouse store.
One way is with something called Treasury Inflation-Protected Securities, or TIPS. They are government-backed bonds that can provide a measure of protection against inflation.
Not surprisingly, investment in TIPS and other inflation-hedge vehicles has soared lately along with consumer prices. But there are some risks.
Here’s a guide.
How TIPS work
You buy TIPS for a certain amount (the minimum purchase is $100, and they’re sold in multiples of $100) at a fixed interest rate. The bonds are issued in terms of five, 10, or 30 years. You receive interest payments—sometimes called coupon payments—twice a year.
If consumer prices rise—as tracked by the Consumer Price Index—the amount of your TIPS principal goes up, meaning your twice-yearly interest payments also go up, although your interest rate remains the same. On the other hand, if prices fall—if there’s deflation—both the principal and interest payments decrease. However, at the end of the TIPS’ term, you are paid either the adjusted principal or the original principal amount when you bought them, whichever is greater.
Charles Schwab offers this hypothetical example: If you bought 10-year TIPS at $1,000 in 2021, maturing in 2031 at an annual interest rate of 0.5%, and if inflation averages 2% a year over the 10-year life of the bonds, you’d wind up with $1,219 in principal in 2031, and annual interest payments would rise from $5.10 in 2022 to $6.10 at the end of 10 years.
What about taxes?
Any increase in your principal each year is taxable as income, even though you haven’t received that money yet, according to the Treasury Department. Interest payments from TIPS are also taxable.
Photo: Andriy Popov via 123RF
Drawbacks to TIPS
Investment experts say these securities tend to be offered at lower interest rates than certain fixed-rate bonds. Also, when you buy TIPS, in effect, you’re placing a bet that there will be continued inflation. If prices fall, your principal amount and interest payments will go down (although, at least you will get back your original principal amount if you hold TIPS to maturity and don’t sell them early).
How to buy TIPS
You can buy them from the government directly online through a TreasuryDirect account. (You can use the same account to purchase other forms of Treasury securities, including savings bonds.) You can also buy them through a bank, broker, or dealer, although sometimes a management fee is involved. And some mutual funds and exchange-traded funds (ETFs) marketed as inflation hedges invest in TIPS and other securities tied to consumer prices.
You might also consider Series I savings bonds, which earn interest by combining a fixed rate and an inflation-adjusted rate. Unlike TIPS, Series I bonds do not pay you interest while you hold the bonds. Instead, the interest is added back into the bonds’ principal, and you won’t receive it until you redeem your bonds. Series I bonds are sold via TreasuryDirect. The Treasury Department offers this comparison of TIPS vs. Series I bonds.
TIPS are worth looking at as an inflation hedge, but only as one piece of your overall investment portfolio since they’re less advantageous if consumer prices go down.