Inflation is the unforeseen foe of an investment portfolio. It neutralizes investment returns by reducing the purchasing power of the dollar. One way to see the effect of inflation is to look at how the price of a bottle of soda has changed over the years.
To protect an investment portfolio against inflation an individual can invest in hard assets, such as precious metals and real estate. The prices of these assets have a history of tracking closely to the amount of inflation in the economy. However, these hard assets can have characteristics that an average investor might be wary of, such as being illiquid, hard to diversify and having outside factors that could affect the price besides inflation.
One relatively new investment vehicle that allows investors to protect against inflation but also removes some of the concerns listed above are Treasury Inflation Protected Securities, better known as TIPS.
TIPS were first auctioned by the U.S. Treasury on Jan. 29, 1997. It is a bond that’s value is adjusted based on the U.S. City Average All Items Consumer Price Index for All Urban Consumers, which is also known as the CPI-U index. The CPI-U index is used to measure inflation and is conducted by the U.S. Department of Labor.
The index releases each CPI-U level in the middle of the following month, for example March’s number this year was released on April 16. As a result, TIPS chose to use a three month lag and as an example the December 2012 CPI-U level would be used to calculate the value of the March 2013 TIPS.
Unlike floating rate debt, where the interest rate is periodically changed based on a predetermined agreement. TIPS change value by adjusting the face value, while leaving the interest rate unchanged. The face value is changed based on the change of the index value of the CPI-U from its initial level when it was first issued to the current level, based on the three month lag.
To keep the math simple let us assume that a 10-year TIPS with 3 percent semi-annual coupon and a face value of $100 per bond is issued on Jan. 1, 2010. The initial CPI-U index level to be used for this particular bond is 215. July 1, 2010, will be the first coupon payment and to determine both the value of the bond and the amount of the coupon we will need the July 2010 CPI-U index level (based on the three month lag), which we will say is 221.
Divide the July CPI-U level of 221 by the initial CPI-U level of 215, which results in an index ratio of 1.0279. Take the index ratio of 1.0279 and multiply it by the face value of the TIPS, which is $100, and the new face value of the TIPS is $102.79. This means if the TIPS matured that day, you would receive $102.79 on top of your coupon.
To determine the semi-annual interest payment you would multiply the new face value by the 3 percent interest rate and divide that amount by two. In the event of a deflationary period, the face value of the TIPS would be adjusted below the initial face value, but upon its maturity the TIPS holder would receive the full initial face value.
With TIPS ability to move up with inflation, it allows an investor to preserve the purchasing power of their initial investment. When implemented as part of a portfolio, TIPS can help diversify and add protection. It can especially be helpful for individuals who value capital preservation above all other investment objectives. Lastly, with inflation becoming a “when-not-if” scenario as a result of the effect of quantitative easing, it may be time to look into TIPS for your portfolio.
Byron S. Sass is a fixed income analyst account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.