If safety of principal is your highest priority, check out Treasury Inflation-Protected Securities, also known as TIPS.
These securities are the focus of chapter six of Marvin Appel’s 2010 book, "Higher Returns From Safe Investments: Using Bonds, Stocks, and Options to Generate Lifetime Income."
As he noted at the start of the chapter, “Inflation is the enemy of the bond investor and is your enemy if you are living on a fixed income. Once you lock in a rate of return by buying a bond, if prices rise faster than your investment is growing, you are stuck.”
If that makes you nervous, Treasury Inflation-Protected Securities could be a solution.
Like regular Treasury bonds, TIPS are issued in units of $1,000. While Treasury bonds retain the same principal value right through until maturity, inflation-indexed bonds will increase at the same rate as the Consumer Price Index. For example, if inflation were to rise 10% over the course of owning a TIPS, then the payout at maturity would be $1,100. If inflation goes up 15%, the payout will go up to $1,150 at maturity.
Note that you need to be the original buyer to enjoy this inflation protection; if you bought a TIPS after issuance, you will not get that protection and might suffer a capital loss if interest rates go down.
In the unlikely event of deflation (the opposite of inflation) and negative interest rates, the TIPS bond will still be worth at least $1,000.
However, if you buy or sell the TIPS after issuance but before maturity, the price will reflect what inflation has done since issuance. For example, if the Consumer Price Index has risen 5% since issuance, the bond will be priced at $1,050.
So, other than that last point, what’s the hitch? Why doesn’t everyone buy these inflation-indexed bonds? Appel explained:
“TIPS would be the ideal investment for retirees except for two big problems: low returns and taxes. TIPS generally pay 1.0%–2.0% above inflation, which means that if you do not want to deplete the purchasing power of your investments, you are limited to spending just that 1.0%–2.0% level of interest income. Most of us have not saved enough to get by on that little.”
And, that’s if you get to keep the one or two points you will earn. The gains in your bond principal are taxed as interest income, the equivalent of receiving an extra cash coupon payment. But, you didn’t get cash -- you got a gain in the value of your bond, while the taxman always wants cash.
Further, in situations where inflation is relatively high, taxes could be greater than coupon payments. Obviously, then, TIPS aren’t much of an investment if you can’t keep them in a tax-advantaged account. There is also a workaround, in which you buy low-cost mutual funds and ETFs that invest in TIPS.
Many TIPS funds and ETFs allow investors to take their taxable contributions in the form of cash rather than additional fund units. Appel reported that most inflation-adjusted ETFs pay cash by default, even if the ETF did not collect any cash from the increasing principal(s).
The author did not recommend owning TIPS funds or ETFs because of uncertainties caused by potential inflation or deflation. Instead, he recommended holding individual TIPS bonds within tax-deferred accounts. This guarantees you will not owe any taxes until you take cash out of your account.
For American investors, he wrote that “the absolute best solution is to own TIPS within a Roth IRA.” A Roth IRA is a special, tax-deferred account in which investors deposit after-tax income, allow the securities within it to grow tax free, and later make withdrawals that are also tax free (in Canada, the equivalent is a TFSA (Tax-Free Savings Account)).
Investors also need to recognize how coupon interest is handled. TIPS bonds pay a fixed rated of interest, in common with regular bonds. However, the coupon interest payments from TIPS will vary, unlike regular bonds.
For example, you buy a TIPS, at issuance, and it has a coupon rate of 2%. Therefore, you expect cash interest of $20 per year ($1,000 x 2%). But after holding the bond for some time, inflation has gone up by 10%, meaning the bond you bought for $1,000 is now worth $1,100. As a result, your coupon interest payment goes up to $22 per year ($1,100 x 2%).
Both the principal value of your TIPS bond and the interest income keep up with inflation. Appel observed, “The only other source of retirement income that provides these benefits is Social Security.”
In conclusion, he wrote:
“The recommended strategy for TIPS is to buy newly issued ten-year TIPS only at real yields of at least 2% ... No other bond investment is as safe as TIPS in terms of both default risk (none) and inflation risk (none).
“TIPS are likely to be more profitable for you than regular Treasuries of the same maturity, assuming that you hold the bond for its entire life.”
Read more here:Ă‚
Higher Returns from Safe Investments: Bond Mutual FundsÂ
Higher Returns From Safe Investments: Bond LaddersÂ
Higher Returns From Safe Investments: Risks for BondholdersÂ
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