OCEAN CITY – Even a relatively minor jump in prices can take a major bite out of the income from the conservative yields of U.S. Treasury bonds, the foundation of so many investor portfolios. But the income and long-term return from one type of Treasury, called Treasury inflation-protected securities, or TIPS, actually improves as the consumer price index rises.
Issued in maturities of five, 10 and 30 years in $100 multiples, TIPS — like other Treasury bonds — pay a fixed interest, or coupon, rate every six months, with the principal due when the security matures. But with TIPS, the principal value is tied to the Consumer Price Index. Suppose, for example, you bought $10,000 in 10-year TIPS with a 1% annual coupon rate. If the annual inflation started out at, say, 1.8% (or 0.9% after the first six months), the bond’s principal value would rise 0.9% to roughly $10,090, when the first six-month coupon payment came due. The semiannual coupon payment would then be 0.5% — half the annual coupon rate — of that $10,090 inflation-adjusted principal value, or $50.45. The more the Consumer Price Index rose, the more the coupon rate would inch up. Just as significant, at maturity investors receive the full inflation-adjusted value of the principal. So if consumer prices rose by a total of 20% over the 10-year life of the bonds, an investor would ultimately receive a principal of $12,000.
Lower inflation would mean a smaller bump in both the principal value and the coupon payments. In the event of deflation, or a decline in consumer prices, the paper value of the principal on which your coupon payments were calculated could dip below $10,000. There is a safety valve built in, though: At maturity investors are guaranteed to receive at least the initial par value, that is the value the bond had when it was issued.
You can understand, then, why investors tend to shun TIPS when inflation appears to be unlikely, as has been the case for the past few months. But rather than hold off on buying TIPS altogether, it’s recommended accumulate them in five- to 10-year maturities over the next year until 3% to 5% of your portfolio is allocated to these bonds.
Even a modest annual inflation rate — roughly 2.1% for five-year maturities and 2.5% for 10-year — will bring the return for TIPS on par with that of nominal Treasury bonds. At a higher inflation rate, TIPS will outpace ordinary Treasuries, potentially by quite a bit.
(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)