Independent Investor: Take a Look at TIPS
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| Bill Schmick |
But over the last six months, Treasury Indexed Protected securities, called TIPs, have proven to be an even more popular and lucrative haven. TIPs offer a hedge against inflation, safety and a chance to profit from future cuts in interest rates.
TIPs are U.S. government-guaranteed securities whose principal and interest payments are indexed to the rate of inflation. Although they have been around since 1997, they have not caught on with the retail-investing crowd largely because inflation has been well contained during this economic cycle. Now, however, with oil kissing $100 a barrel, gold (a traditional inflation hedge) at all-time highs and basic stables, like milk, soaring in prices, inflation has returned with a vengeance.
TIPs partially remove one of the main risks to bond buyers - inflation risk. The twice-yearly interest payments on TIPS are indexed to the Consumer Price Index, the government's main inflation barometer. If inflation ratchets up like it has over the past few months, the bonds interest payments and principal increases by a like amount.
TIPS are sold in $1,000 increments through electronic auction and are issued in terms of five, 10 and 20 years. They can be held to maturity or sold in the secondary market. Most individual investors prefer to buy TIPs through a broker or invest in TIP funds called "real return" mutual funds offered by Pimco, Fidelity, Vanguard and a half-dozen other big-fund managers.
As fears of recession pummel stocks and credit concerns make even the most AAA-rated corporate bonds suspect, the appeal of the U.S. Treasury market grows ever stronger. Just last week a story surfaced that caused investors even greater concern. Tax-free municipal money market funds, the other safe-haven investment vehicle in times of turmoil, has come under a shadow. Bond insurers, those corporations that traditionally insure municipal bonds from default, have come under scrutiny thanks to their exposure to the subprime mortgage markets. To date, their problems have been contained but the future is murky at best.
Government bonds, unlike everything else, have no default risk. Your principal investment is safe from bankruptcy but that doesn't mean they're riskless. You still have inflation risk (unless you invest in TIPS) and all bonds have interest rate risk.
Bond prices and interest rates have an inverse relationship. Interest rate-risk for a bond buyer occurs when rates go up. That causes the price you paid for your bond to immediately adjust downward. Of course, the opposite occurs when rates drop. Buyers benefit as their bonds increase in price so you want to own bonds of any sort when the Federal Reserve cuts interest rates as they have been doing since the fall of 2007.
I believe we are already in a recession and expect further rate cuts over the next several months to stimulate the economy. I also expect that these rate cuts will cause even higher inflation. Given the volatility in the stock markets, it's an environment tailor-made for a government-guaranteed, inflation-indexed security like a TIP. Is it any wonder that they have suddenly become popular?
So where's the catch? Because so many investors are buying into these bonds the return on TIPs is dropping. They are only yielding 1.7 percent or so, down from 2-plus percent historically. Yet, money market yields are also plummeting and money funds have no shot at price appreciation if rates are cut further.
There's also a tax issue involving "Phantom Income," the subject of a future column but for now, just know that TIPs are best bought in tax-deferred accounts like IRAs and 401(k)s.
In my opinion, investors in TIPs are far more concerned with the increasing risk in the financial markets. They are intent on preserving their capital rather than generating a return in the short term. They are betting that the economy is sinking into recession as the credit crisis forces more problems in the financial system, despite government efforts.
The Federal Reserve will cut rates in response, which will create higher inflation and so the prices of their TIPs investments will continue to move up. Right now, I think the prices of TIPs are pretty rich. My advice is to wait for a pullback (which should happen fairly soon) before jumping in but over the long haul these bonds seem like a good bet.
Bill Schmick is a registered investment adviser representative and portfolio strategist with Berkshire-based Dion Money Management, managing over $900 million for middle class Americans from coast to coast. Direct your inquiries to Bill at 1-877-850-7942, Ext. 146 (toll free), or e-mail him at wschmick@dionmm.com.
