Treasury Inflation Protected Securities are not the same as an investment that protects you from rising interest rates. While it is easy to see how investors can be confused by this, it will be a very costly mistake if you made it. In a follow-up to our warning about the potential, even probable bubble in the bond market posted a couple of days ago, investors who sought refugee in this type of security will also find trouble on the horizon.
A good deal of you moved into bonds without really knowing what you were getting into. A portion of you went with the safest bond available, the Treasury bonds. These are purchased at face value and pay a coupon (or interest rate payment) based upon the agreed upon rate at the time of purchase. Inflation can take its toll on those “yields”, as the interest paid to you is often referred to. Real yield however is the coupon payment less inflation. If inflation is low, as it has been over the last year or so, the yield on your bond will be relatively predictable and even quite profitable.
Based on the Consumer Price Index (which excludes food and fuel due to volatility and is based on a basket of consumer goods), inflation is often considered the real cost of long-range investing. It determines how much your yield is really worth. But there is a Treasury bond available that seeks to counteract inflation: TIPS.
Treasury Inflation Protected Securities work the same way as regular securities with one exception: as the CPI goes up, so does your yield, protecting you against a lower return as inflation rises.This is all well and good if there isn’t too much activity – in other words, not too much trading. As people buy more bonds, the price goes up. And because bonds are what they are, yield falls. Just a decade ago, TIPS would have produced about a 4% yield. Now because everyone it seems wants a piece of the protection guarantee these securities offer, the yield is in the 1.5% range.
So the answer to the question of buy them or not? Yes but in the shortest term possible. With TIPS, the longer the maturity, the greater the chance of a drop in price. And because we expect interest rates to rise and we know that they generally are behind where in inflation is, most investors should see the warning signs long before the real trouble begins.
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