Treasury Inflation Protected Securities (TIPS) have the properties of a bond. Since bonds are just a kind of loan, we can expect to get our money back when the loan period is over. What makes TIPS especially attractive, however, is…
Treasury Inflation Protected Securities (TIPS) protect investors from inflation by automatically adjusting the original face value of the bond for inflation. What I have discovered is that this feature is used for different purposes by different people. I tend to use TIPS as a method of saving principal, but there are those who use TIPS as a “hedge” against inflation within a larger portfolio of riskier investments.
The Saver’s View
I discovered that the way that I look at TIPS is much different than the way investors tend to look at them. Since I look at TIPS as a way to save money for the future, I’m not very concerned about my returns. I’m just trying to preserve the returns that I have already received. I’m also trying to make sure that all of this money is available on a specific date. I also intend for that money to be adjusted for inflation.
The Investor’s View
When investors use TIPS, they are usually trying to make sure that if there is a downturn in other investments that are sensitive to inflation, that they own something that counteracts inflation. This allows their portfolio to lose less money or perhaps even gain money as a result.
Very Different Intentions
These two perspectives come from two very different intentions on the part of the bond holder. One person is trying to preserve and the other is seeking opportunity. This is why I recommend that you divide your money into two parts as I describe in the article: Stressed about Savings? Divide and Conquer!
The Investor’s Bond Market Focus
When we look at TIPS from the perspective of an investor, we are more concerned with counteracting inflation. This can be done by trading bonds that are sensitive to inflation. To TIPS traders, the current market value is more interesting than the adjusted principle. An investor is less likely to hold a TIPS to maturity. For TIPS investors, TIPS mutual funds or ETF’s may make sense. Trading TIPS on the secondary market may also be useful. Bond market traders are also very interested in Yield to Maturity (YTM). That’s because they are concerned with the return on investment. Without a good return, it isn’t a very good opportunity. This may not be a big deal in some investor’s minds because the inflation protection may be worth a loss in that part of their portfolio, however.
The Saver’s Inflation Protection Focus
When we look at TIPS from the preservation of savings point of view, we aren’t interested in the market value of TIPS. We are interested in the adjusted principle. Since we intend to be getting this principal someday when the bond matures, that’s all we really care about. We are more interested in seeing how well our savings is being protected, rather than seeing our yield to maturity. As preservers of principle, we are willing to pay some or even all of our yield to make sure that we have our money when we need it.
Taxes are a serious problem for both the investor and the saver. This is one place where the two views tend to come together. Taxes can make it difficult for an investor by taking money away during a successful time causing the money to not be there for a time when things aren’t so successful. This makes swings in income even worse.
For savers, taxes can actually cause us to lose money due to inflation as I explain in the article: “Inflation Protection and Taxes.” Since we don’t make much interest on a savings style investment, taxation can make our preservation costs unpredictable and threaten our attempts to preserve once again.
Be Careful Not to Mix Views
It can really cause you to become paralyzed as to what to do with your money if you flip back and forth between the investing and savings views of looking at TIPS. I find that it is wise to make a conscience effort to think one way or the other when choosing what to do. I tend to use them for savings preservation. I see very little help out there when it comes to looking at these bonds from this perspective. By viewing TIPS in a way that matches your needs, you will be able to make more confident decisions with them.
Copyright © Troy Taft 2020
It’s important to understand that inflation protection is removed when taxes are applied. Current tax rules disregard inflation, and as a result it’s easy to demonstrate that inflation can cause all of our interest on a TIPS and some of our principle to be lost through taxation alone.
When we consider our inflation adjusted returns, we can easily see that the real tax rate climbs to astronomical levels. This simple example shows how easy it is for taxes to use up all of our real returns.
A Revealing Example
Let’s consider the effects of taxes on our inflation adjusted gains. These adjusted gains are what finance professionals call our “real” gains.
Let’s use the actual TIPS that is being offered as I write this and our current inflation rate. Our current inflation rate is actually 2.2% but we will use 2% make it easier and more conservative. If you buy a $1000, Ten year TIPS with a 0.5% interest rate and experience inflation that averages about 2% during that time, the overall real gain would be 5% over 10 years and the overall inflation adjustment if it stayed the same during that period would be 20%.
After 10 years, your principle would be adjusted to $1,200 and you would have been paid about $60 in interest. The problem is that you are not taxed on the just the $60. The tax rules require that you be taxed on the $60 real gain + the $200 of principle adjustment. If you are paying taxes at a low 15% rate, the rules say that you must pay 15% of $260 or $39. Since you really only earned $60 in real value, you will have paid 65% in taxes.
That’s a very high tax rate for sure, but look what would happen if we had an unusual amount of inflation. This is something we need to consider because our intention is to protect ourselves from both average and unusual changes in inflation.
Let’s change the average inflation to 5%. After 10 years, your adjusted principle would now be $1500 and your 0.5% interest would be $75. Your tax on $575 at 15% would now be $86.25. Since you only really earned $75, taxes will have taken all of your real gain and forced you to take a loss of $11.25 on top of that. That comes out to be a real interest rate of -0.1125% and a real tax rate of 115%.
In a taxable account, the greater the inflation, the less the protection. I can’t honestly say that it provides any protection at all because a taxable account amplifies inflation. It is wrong to assume that our savings is inflation protected just because we hold a TIPS.
One Safe Place
If you open a tax advantaged account such as a 401k or an IRA at a brokerage that allows you to hold TIPS within it, your savings is guaranteed to be protected. That’s because all growth in a tax advantaged account is either not taxable or tax deferred. This means that all inflation adjustments to your TIPS principle will only be taxed once, either before you put it into a Roth IRA or 401k or after you take it out of a traditional IRA or 401k.
The combination of a tax advantaged account and TIPS is currently the only option that I am aware of that will guarantee inflation protection to a person attempting to save money in United States.
I Bonds are Only Guaranteed in Certain Cases
I Bonds are tax advantaged in that they are exempt from state and local taxes. That makes them an even better option than other “safe” investments. This still does not protect them from a total loss of real gains through federal taxation on inflationary gains. There is one more advantage though. If an I Bond is used for tuition, it is tax free and becomes a great way to save for a child’s education.
It is also possible to sell your I bonds at a time in which your taxable income is below your exemption allowance. If your total income falls below the your permitted exemption, then your I Bonds are tax free for that year.
A Problem for All Investments
It’s very important for all investors to understand that this problem exists outside of TIPS and I Bonds. As far as I know, all investments have the potential of losing all of their real gains through taxes that are amplified by inflation. Here’s an explanation of the effects on capital gains:
It’s not just a problem for investors, though. Inflationary gains are taxed in your very own bank account. Your interest may be only $1 per year, and you may have actually lost $5 of purchasing power in your account. You would think that would mean that you lost $4 in purchasing power. Since you pay taxes on your inflationary gain of $1, it pushes the loss even lower than $4. Inflation amplifies your taxation because the more inflation there is, the more tax you pay.
Important Things to Remember about Tax Advantaged Accounts
If you have the ability to have 401k, I highly suggest that you do that. IRAs only allow you to contribute $6,000 per year for those under the age of 50 and $7,000 per year for those over 50. 401k’s allow you to hold far more depending on your income.
If you are a high-income individual. You currently have no guaranteed protection from inflation for savings that I know of. It may be a good idea to consider moving your investments overseas. There are several nations that don’t have capital gains taxes including Mexico and New Zealand.
Copyright © Troy Taft 2020
I got an interest payment from one of my TIPS recently. It feels pretty good to watch your income automatically go up with inflation. As I mentioned in the article: “Introducing Treasury Inflation Protected Securities (TIPS)“, these bonds pay out interest on your inflation adjusted principle. The percentage of interest stays the same, but the bond amount itself goes up as it is adjusted for inflation. That means that your income goes up too.
What I feel when I get my inflation adjusted income, may be a result of the fact that I’m so used to being charged an inflation premium. All I’m really experiencing is consistency. I’m just getting the same purchasing power from my money as I had when I purchased my bond. As I considered the fact that loaning out money is capable of producing an ongoing, inflation protected income, I realized that this could be used to create a reliable income and preserve the principal at the same time.
Considering the Possibilities
I don’t talk very much about the income from TIPS because I primarily focus on their ability to protect our savings, but if you have enough money and don’t want to risk it somewhere else, you could use TIPS as a way of getting inflation adjusted income for the rest of your life while also protecting your principal.
You’re intention would be to preserve the principal for the rest of your life. Perhaps you already have a large sum that is intended for your heirs or for charitable giving in your will. You could be using that money to generate an income while keeping the principle safe and adjusted for inflation.
Even if you don’t really need the income, you could generate it and give it away while you are still alive.
Making Your Own Annuity
There’s really nothing new to creating your own “annuity” with TIPS. It’s just a frame of mind. The only difference is that you are using TIPS for the purpose of generating income. If you do plan to use them in this way, you might consider getting the 30 year TIPS. Not only will the income stay consistent for 30 years, you usually get the highest amount of income from the longer term bonds.
Keeping it Real
You might be wondering why you wouldn’t just use CD’s for this purpose. Remember, that the interest rate for TIPS is a “real” interest rate. That means that inflation has already been calculated into the TIPS interest. You have to subtract the inflation rate from your CD’s current interest rate and then compare it to the TIPS rate.
If, for instance, the interest rate on your CD is 2.04%, and inflation is currently at 1.90%, your real interest rate for the CD is only .14%. If you compare that to a 1% interest rate on a TIPS, you would see that you would earn .86% more “real interest.” That’s a whopping 614% more income on the same principal.
There really aren’t any fees when you buy a TIPS, but I like to consider any bond premiums and taxes as fees when you make an annuity out of them.
A premium is when you pay more than the face value for the bond. This happens when you buy a TIPS at auction and the price for the TIPS goes above the TIPS amount itself. It can also happen when you buy a TIPS from someone else on the market. For instance, you may end up buying a $1000 TIPS for $1100 at auction. If you do, you are paying a premium of $100 to get a $1000 TIPS. That $100 is like a fee because you had to pay it up front just to get the bond. It could take a while to recover that fee, but if you are doing it to protect a future income stream from inflation, it may not matter much to you. You are paying for a guarantee, just like you would with insurance. As long as you are still working, you can pay that fee with current income. This is a way of protecting future income while you have current income.
Taxes are a similar kind of thing. With TIPS, taxes are like an annual fee. You could think of it as a fee to the government for using their system to protect your money. The fee is paid at your tax rate. The bad thing about this fee is that it goes up with inflation. That makes this fee pretty expensive in a high inflation environment.
These fees may still be acceptable to you for protecting your income stream. With a commercial annuity, you may end up in the same place when you calculate in the loss of principal to your heirs.
If you were to put this annuity in an IRA or 401k, you would completely remove the tax “fee” and if you were careful to only buy your TIPS at a discount instead of a premium, you would also not have to pay the premium “fee.”
You’re the Boss
The thing that makes this so much better than a commercial annuity, is that you have complete control over the principal. The terms are very clear and your investment is backed by the full credit of the United States. All of the money is still under your control.
If you are wondering why you’ve never heard of this before, it might be because there is no money in this kind of annuity for anyone else but you. When you build your own TIPS annuity, you get to decide what to do with the principal and your heirs get it all back in the end without any exposure to the markets.
Copyright © Troy Taft 2020
Bonds are one of the easiest and most common ways to save money for the long term. There’s a good chance you already own one. If you have a certificate of deposit at your bank or your credit union, you own a kind of a bond. CD’s are quite a bit different than other kinds of bonds, but they have many things in common.
Rather than going over different kinds of bonds, I’d like to explain why they are a good investment for those of us saving for future needs. In a previous article, I described two ways of looking at our investments. Bonds are very useful for the part of our savings that we intend to preserve.
Bonds Eliminate Timing Risk
I mentioned back in my introduction to TIPS that bonds are actually a type of loan. CD’s are loans that you make to the bank. If you ever wondered how to turn the tables on a bank and get them to pay you interest, that’s how. If you have had a CD before, you know that it has an end date. That’s how bonds work. They “mature.” When they do, you get your money back.
Because bonds have a due date, they are great for eliminating timing risk. Bonds come with a promise to return your money on a specific day. If you intend to go on a big vacation in two years, you can get a two year CD at the bank and earn higher interest than you would in a regular savings or checking account. When the CD matures, you get your money back and all the interest right when you need it.
You can imagine what might happen if you put that money in a mutual fund for two years. If you happen to have planned your vacation during the next stock market crash, you probably would have to change your plans. It might be ok to miss your vacation, but putting off your retirement because you took that risk would probably be a bigger deal.
Certificates of Deposit and Inflation
Taking out a two year CD might not be that bad. At the time I write this, CD rates are still quite a bit lower than the rate of inflation. When that is true, you end up paying the bank to hold and protect your money. That’s not always a bad idea. Putting all that money in your house might be worse, but it sure would be nice to be able to keep up with inflation don’t you think?
I Bonds vs. CD’s
You might consider I Bonds for a two year holding time or more. You can’t take your money out for the first year, so if you need the money sooner than that, it wouldn’t be a good idea. If you need the money in less than five years, it would still be a pretty good idea to put your money in an I Bond because it protects your purchasing power at the cost of losing three months of interest. It’s still better than most bank CDs at the time that I write this. After five years of waiting, you can take the money out any time. If you have more than 30 years to wait, you will have to sell your bond in thirty years and get a new one. You can find out more about I Bonds in another article.
The advantage of using an I Bond over a CD is that you are more certain to keep up with inflation. There are CD’s that allow you to “step up” your interest rate if the interest rates go up at some point. The problem with that is that interest rates and inflation are not really linked. The will of the government is in between. Governments occasionally force interest rates lower as a way to “fix” the economy. As a result, CD’s have proven to not be a very precise way to protect your money’s purchasing power.
Using a Bond Ladder
You may have seen an article or heard someone at your bank talk about putting some money in a CD ladder. This arrangement helps you take advantage of changes in interest rates over time. It’s another way to attempt to deal with inflation issues as well.
The idea is that you split up your money, and buy CD’s or bonds with different maturity dates. For instance you might buy one for six months, another for one year and another for two years. The idea being that every six months you would have a CD coming due. When it does, it allows you choose whether you need to use some of the money or put it back into another CD. It also allows you to take advantage of changes in the interest rates as they go up.
When you are trying to save your money for later, bond ladders have much different purpose. When you are using inflation protected bonds like I Bonds or TIPS you don’t really have to worry about the interest rates. Remember that taking advantage of rising interest rates is the kind of thing we do with the part of our money set aside for opportunity investing. When we are dealing with the preservation side, what we concern ourselves with is timing. We just need to ask ourselves: When do I need this money? In this case, we would use a ladder to put the right amount of money in the right place in the future to meet our needs.
Here’s an example. Suppose you need your money in 15 years. It may require that you take out a ten year TIPS, and after 10 years you need to remember to buy another 5 year TIPS when it matures. You can think of your needs like buckets of money. Let’s say that you have one bucket for each year during your retirement. You need a ladder of bonds that reach to each bucket in order to fill them with the right amount of money so that you meet all of your needs.
Beware of Bond Mutual Funds
Bond mutual funds don’t have a maturity date. Shorter duration funds may be safer than stock funds, but they are definitely more risky than just owning the bonds. That’s because the fund share prices change every day based on market forces, not inflation. I plan to explain that more in an article about mutual funds.
A Smart Way to Plan
Bonds are a great way to plan because they are based on time commitments. Not everything in life can be planned, but for things that need to be, it really makes sense to use investments that have commitments built into them so that you can be sure to have money when you need it.
Copyright © Troy Taft 2020