The US treasury inflation-protected securities (TIPS) are a simple and effective way to eliminate one of the most significant risks to fixed-income investments, which is the inflation risk.
While doing that, the securities provide a real rate of return that is backed and guaranteed by the US government.
And because of that, it is very important and worthwhile to look into and understand how these instruments work. You should also know how they move and how they can be incorporated into an investment.
Over time, inflation can erode the buying power of interest payments. And investors bear this inflation risk with normal or nominal fixed-income investment.
TIPS, on the other hand, are guaranteed to keep pace with inflation as described by the consumer price index (CPI). This is practically what defines and differentiate TIPS.
Because TIPS shield investors against inflationary concerns and nominal bonds do not, they can move very differently from one another.
To be specific, nominal bonds will become less favorable as inflation increases, since the value of future interest payments are eroded by inflation.
In a similar manner, as inflationary concerns decrease, nominal bonds become more appealing relative to TIPS as future interest payments turn out to be more favorable on a real basis.
How to Buy TIPS
You can buy TIPS in the same manner as any other fixed income investment. You can directly buy them as individual bonds through the US Treasury or a broker. You can also buy them through a mutual fund.
If you are investing to match specific cash flow requirements, it better makes sense to buy individual bonds.
For this matter, buying the bonds directly from the US Treasury is the cheapest choice. On the other hand, if your goal is to receive a fully diversified fixed-income portfolio made up of TIPS, you can choose to invest in them through mutual funds. Low-cost index funds are your best choice.
The Role of TIPS in a Portfolio
When it comes to portfolio asset allocation, fixed income instruments play a crucial role for all kinds of investors.
You have to keep in mind that over prolonged periods of time, fixed income provides returns that are a a lot lower than equities.
However, it also provides much lower levels of return volatility. And because of that, fixed income functions to reduce overall portfolio volatility, particularly during times of market stress when equities may decline significantly.
TIPS also provide additional levels of diversification above the nominal fixed income. They do that as they get rid of the risk of inflation for whatever portion of the portfolio they make up.
As a result, they often present even lower risk levels than nominal bonds, which are usually subject to inflationary concerns.
When you combine TIPS with nominal bonds, the fixe income portfolio will inevitably become less volatile, and the same goes for the portfolio as a whole.
You can also use TIPS tactically to time the market as according to your expectations for inflation movements.