Now that inflation is high, is it time to buy Treasury Inflation Protected Securities (TIPS)?
Inflation is the highest it’s been in 40 years. You might think an “inflation protected” investment would be just the ticket right now. Unfortunately, it’s not that simple. Many TIPS have negative yields today. Instead of the TIPS paying you interest when you own them, they effectively cost you money to own. That’s because there is high demand for TIPS right now so they are not a bargain. We wouldn’t recommend them for short-term inflation protection, though they could be a decent long-term inflation hedge.
Here's a short primer on how TIPS work. TIPS are a type of Treasury bond issued by the U.S. government. The difference is that the value of the principal (the bond itself) fluctuates based on the Consumer Price Index (CPI). If the CPI increases, so does the value of the bond. TIPS pay a fixed rate of interest, but the amount of interest can change since it is based on the value of the bond multiplied by the rate of interest. As an example, an investor with $100 worth of TIPS with an interest rate of 1% gets $1 per year. If inflation is 5%, the TIPS are now worth $105 and the investor gets $1.05 in interest every year. The opposite happens in the case of deflation.
However, TIPS are priced for current conditions. In order for the value of your TIPS to increase, inflation would have to remain high. Otherwise, you could be locking in a negative yield on these bonds by buying today. Right now, TIPS have a lower rate of interest compared to Treasury bonds. For example, TIPS maturing in 2 years are yielding -0.443%. A 2-year Treasury yields +2.839%. That’s a difference of 3.282 percentage points. You would be better off buying a Treasury for now since your interest rate would be over 3 percentage points higher than for TIPS. However, if the CPI increases, the value of the TIPS would increase, whereas Treasuries stay the same. This could eventually provide a higher return for TIPS owners. People buying TIPS at these rates are banking on high inflation in the next two years. And we can see investors are willing to pay quite a lot for this inflation protection.
Considering these numbers, we find it hard to recommend TIPS for inflation protection over the next few years. They are solid choice for long-term protection. If you plan to hold them for 10 years of more, there is a good chance you will make a bit of money and they do offer peace of mind if you are worried about inflation. We still believe the best long-term hedge against inflation is stocks. However, TIPS can be useful in limited circumstances.