Are TIPS a Good Inflation Hedge?

Central banks worldwide have ramped up their bond-buying programs to support their respective economies' recovery from the global pandemic and subsequent recession. While these efforts may have helped economies stabilize, the influx of bond purchases in 2020 could usher in a new inflation era.

Interestingly, the Federal Reserve recently stated that inflation isn't breaching its 2% target level in the near term. In his comments following the December Federal Open Market Committee (FOMC) meeting, Fed Chair Jerome Powell stated, "… even with the very high level of accommodation that we're providing both through low rates and very high levels of asset purchases, it will take some time."[1]

However, the Fed's comments may have done little to ease some investors' minds as we head into the New Year. The reality is that the Fed will continue to buy bonds and keep key interest rates at near-zero levels until the U.S. economy improves and inflation rises back to 2%. So, it's not a matter of if inflation will rise. It's a matter of when.

As a result, some investors may consider investing in Treasury Inflation-Protected Securities, or TIPS, to hedge against inflation's impending return. Let's consider what these securities offer and if they're viable investment options in the current environment for those unfamiliar with TIPS.

As you may have gathered from the name, TIPS are a Treasury security designed to protect investors from an increase in inflation. Simply put, the TIPS price is adjusted as inflation rises to preserve an investor's purchasing power of money.

Aside from the inflation hedge, TIPS can also be attractive to some investors because of the interest income. TIPS pay interest based on a fixed interest rate every six months determined when each TIPS issue was first created.

It's important to note that the semi-annual interest rate payments will vary based on the TIPS' principal value. If the TIPS' price increases to reflect inflation, the fixed interest rate is applied to a higher principal value, hence a larger interest payment.

However, the opposite can also occur. The TIPS' price will adjust down in a deflation period, so the fixed interest rate would be applied to a lower principal amount. If this happens, the semi-annual interest paid will fall.

TIPS are often viewed as a "risk-free" investment, in that the investors always receive at least the original principal at the time of maturity. If inflation rises during the TIPS' life, then the original principal could be adjusted higher, and interest payments could grow. On the flip side, if deflation occurs, then the principal could be adjusted lower, and interest payments would drop.

In my opinion, TIPS are another Wall Street packaged product that we need to consider with a wary eye.

The issue with packaged products—in this case, interest income plus inflation hedge—is that the package's cost can outweigh the economic benefits of ownership, such that the liquidity forgone by investing in the TIPS instrument may not be worth the potential return. Does it cost more to buy a packaged product versus doing it yourself? Or, in other words, is the cost of conveyance too high?

If you're looking for inflation hedges as we head into the New Year, contact us at Nicollet Investment Management today. We'd be happy to set up an appointment to discuss what options are best to help you achieve your financial goals.

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[1] https://www.cnbc.com/2020/12/16/fed-meeting-live-updates-watch-jerome-powell-speech.html