After enjoying a lengthy period of low inflation, developed economies are now facing rising costs.
The pandemic which had shut down the global economy has led to a surge of demand as economic activities resume and countries begin to open up borders. Supply chain constraints and easy monetary policies from the central banks to stimulate economic growth have driven the costs of production and price of consumer goods upwards.
The shifting landscape of the economy calls for portfolio restructuring towards assets that can hedge against the eroding effects of the loss of value that comes with inflation. One alternative which would be at the top of most investors' checklists is the Treasury Inflation-Protected Securities (TIPS).
Contrary to popular opinion, investing in TIPS isn't always straightforward. Investing in this asset comes with unique features that can make it somewhat confusing, especially for those who want to test the waters. This article offers a guide to beginners on the best strategies to invest in TIPS and getting more from using them as a vehicle to beating inflation.
As the name implies, Treasury Inflation-Protected Securities are a security issued by the United States Government and are designed to protect investments against inflation.
TIPS are securities whose principal tracks the rate of inflation. As inflation rises and falls, the value of TIPS increases and declines. Interests (coupons) on TIPS are fixed, but actual coupon payments fluctuate based on the underlying principal value.
For example, if you invest $1,000 in TIPS which pays a coupon rate of 2%, at the end of the year, you would earn $1020.
If inflation rises to 3% the next year, the principal amount would be adjusted to $1,030. The coupon rate remains the same at 2% but would be multiplied by the adjusted amount ($1,030) to arrive at an interest payment of $20.60 for the year.
The principal value on TIPS is adjusted twice a year for inflation based on changes in the Consumer Price Index (CPI), a metric used to measure inflation by tracking changes in consumer goods. At maturity, if the face value is greater than the issue price, you will receive a higher yield on your principal.
By adjusting the rate of inflation, the intrinsic value of TIPS is protected and maintained. As the inflation rate rises, the value of investor's assets is protected from the eroding effects of the rising inflation. It also ensures that investors do not receive less than the originally invested principal due eroding effect of inflation.
You can invest in TIPS by purchasing them directly from the U.S. Treasury or through your (online) broker. TIPS can be purchased through the primary or secondary market.
While you buy at the issue price in the primary market, in the secondary market it is very possible to buy TIPS below the face value.
If you choose to buy TIPS on the secondary market, be sure to compare the current par value with the issue value. A buyer would look to purchase below the issued par value, while a seller would be looking to sell above the issued par value.
You can hold a TIPS until it matures, or sells it before it matures. However, this means that deflation could drag the par value below the amount paid, thereby leading to a loss. If you do not wish to buy TIPs directly, you can also buy Mutual Funds and ETFs that track TIPS.
By adjusting the principal value for inflation, this ensures that investors will never be paid less than the initial amount invested. As such, investors would not incur a loss.
TIPS are backed by the U.S government, which means that the risk of default is very low. As such, investors are guaranteed the safety of their capital.
TIPS can also be used to diversify the portfolio, thereby reducing overall risk to investment and providing a hedge against inflation.
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Because they are adjusted for inflation, TIPS have a lower interest rate than most government securities.
TIPS usually have a high tax bill. The semi-annual coupon payments are subject to federal income tax in the year in which it happens. If you decide to hold till maturity, you would also be required to pay federal income tax.
TIPS derive their utility from inflation. As such, they lose value in periods of deflation or when inflation is low, as other investment assets such as equities would look more profitable.
Investing in TIPS depends on the investment objectives.
If you seek safety and want to preserve your capital, then TIPs are a good bet. However, if your objectives are profit-driven, TIPS are not suited to such goals. TIPS are good investment choices for investors that want a long-termed and low-risk approach to investing.
They are also a good investment choice if you want to put money away for a particular project or goal eg. your kid's college tuition.
The seasonal performance of TIPS makes them suitable for only certain periods. It is best to invest in TIPS when inflation is on the increase. When inflation is low, TIPS do not make for a good investment, unless you intend to hold till maturity.
TIPS are a worthy long-term consideration for your portfolio, especially if you are worried about inflation.
They can provide a safe haven for capital because of the low risk of default. However, before you decide to take the deep dive, consider the taxes you would incur from coupon payments. An understanding of the best time to trade them in is also key.
To optimize the gains from TIPS, it is best to sell when inflation is high, and buy when inflation is low.
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