When it comes to> retirement savings, preserving principal has always been a key concern. But these days, with unprecedented market swings tearing into investors' savings, it's even more important.
One way to protect your nest egg from the ravages of both inflation and deflation is to invest a portion of your portfolio in U.S. Treasury Inflation Protected Securities (TIPS). TIPS are typically sold with terms to maturity of five, 10, and 20 years. They pay cash interest twice a year at fixed rates. For example:
* The five-year TIPS maturing on 4/15/16 pay interest at the stated annual rate of 0.125% and are currently trading at a premium in the secondary market to yield about 0%.
* The 10-year TIPS maturing on 1/15/22 pay interest at the stated annual rate of 2.5% and are currently trading at a premium to yield negative .20%.
TIPS in an inflationary environment
In times of inflation, TIPS principal balances are adjusted upwards twice a year based on changes in the Consumer Price Index. You receive the higher inflation-adjusted principal balance at maturity so inflation won't hurt you. That wouldn't be the case if you follow the knee-jerk conservative investment strategy of buying regular U.S. Treasury notes or bonds. Buy them and bad inflation could hurt you badly.
With TIPS, you receive cash interest payments twice a year. Each payment equals half the stated annual interest rate times the inflation-adjusted principal balance at the time of the payment. So your interest payments go up with inflation, too.
TIPS in a deflationary environment
If you buy TIPS with care and hold them to maturity, your investment will do OK even if there's significant . During these times, TIPS principal balances are adjusted twice a year. Interest payments are also adjusted downward because they are based on declining adjusted principal balances. (The stated interest rate itself doesn't change.)
However, even if there's severe deflation, the results from owning TIPS won't be too bad -- you'll still get interest payments and you'll still get full face value at maturity.
Example: Say you buy at face value $50,000 of 10-year TIPS that pay 1.5% stated interest. If you hold to maturity and inflation runs at an average of 7% during your ownership, the annual return will be about 8.5% (1.5% interest + 7% inflation adjustment). If you instead buy at face value $50,000 of regular 10-year Treasury notes that pay 2% interest, your annual return will be 2%.
If there's deflation, the return on TIPS will still be positive, but it will be less than 1.5% (because the interest payments will go down as the adjusted principal balance deflates). With regular Treasurys, deflation does you no harm. You'll get your 2% no matter what.
Bottom Line: Currently, TIPS have a big advantage over regular Treasurys if there's significant inflation and a smaller disadvantage if there is significant deflation.
Buying newly issued TIPS versus older ones
When you buy newly-issued TIPS directly from the government, nothing bad can happen to the principal -- assuming you buy at face value (or below) and hold onto them until maturity. At maturity, you'll receive full face value even if there's heavy deflation.
But if you buy older TIPS in the secondary market, you'll have to pay for the accrued inflation adjustment to the principal balance. The problem is that amount can vaporize with deflation. The way to avoid this risk is to buy TIPS when they are issued or shortly thereafter (assuming you can buy them at face value or below). That way the accrued inflation adjustment will be little or nothing, and you'll have less to lose in the event of deflation.
When you hold TIPS in a taxable account, you must pay current federal income taxes on both the cash interest payments and the inflation adjustments (if any) to the principal balance. Paying current taxes on the inflation adjustments isn't a great way to go -- because you won't actually collect those inflation adjustments in cash until the TIPS matures or you sell them in the secondary market. To avoid this problem, hold your TIPS in a tax-advantaged retirement account, such as a traditional or Roth IRA, 401(k) or SEP.
How to buy TIPS
The minimum face value for TIPS is $1,000. Larger denominations are available in $1,000 increments. TIPS are marketable securities, so they can be easily bought and sold in the secondary market through a brokerage firm. Just be aware that you'll have to pay a commission. However, these fees tend to be reasonable.
Original issue TIPS can be purchased from the government through the online Treasury Direct program. However, the Treasury Direct option is only available for TIPS purchased for taxable accounts, which, as I explained above, is generally inadvisable.
One thing to keep in mind with TIPS is that market prices fluctuate due to changes in prevailing interest rates, supply and demand, and other factors. If you don't intend to hold TIPS to maturity, you must understand that market prices can and do change on a daily basis, and there is no certainty about how much you'll be able to sell TIPS for in the secondary market.