Looking into the crystal ball of the next twelve to thirty-six months, many prognosticators are suggesting that inflation will rear its ugly head after more than a decade of hibernation. In fact, early indications are that inflation is beginning to heat up. The February 7 issue of Forbes Magazine states that the core consumer price index has more than doubled over the past year, representing the largest rise since 1990. What are the indications of rising inflation for your investment portfolio and what adjustments, if any, should you consider making?
In an attempt to keep rising inflation in check, the Federal Reserve, lead by Alan Greenspan, has raised interest rates 5 times in less than 12 months. This trend is almost certain to continue throughout 2005 and much of 2006, which will spell trouble for holders of bonds with mid to long maturities. If you believe inflation will be increasing in the coming months, then you might want to consider buying U.S. Treasury Inflation Protected Securities or TIPS. As with regular Treasury bonds, TIPS pay interest semi-annually but your interest payments and your redemption value at maturity is based on inflation (CPI-U). If inflation rises every year that you own your TIPS bond, your interest payments and your value at maturity will also rise. Because of this feature, the comparable interest rate paid on a TIPS bond is lower than a regular Treasury bond. Currently the difference is approximately 2.6%. This means that you should buy TIPS bonds instead of regular Treasury bonds if you expect inflation to rise more than 2.6% for the term of the bond you are purchasing. In the unlikely event that there is deflation during your holding period, you are guaranteed that the redemption value at maturity will never be less than par but your interest payments would decrease.
TIPS can be purchased in 5, 10, and 20 year maturities and may be purchased directly from the Treasury Department (www.treasurydirect.gov) or through a brokerage firm. TIPS owners pay federal income tax on interest payments in the year they are received and on growth in principle (called principal adjustments) in the year that it occurs. Note that the increases in value due to principal adjustments creates what is called ‘phantom income’. In other words, you owe taxes on money that you did not receive. Therefore, TIPS bonds may be most appropriate when held in your retirement account, particularly for 10 or 20 year bonds.
One of the newest ways to get involved in the TIPS marketplace is through an Exchange Traded Fund (ETF). With an ETF, you are actually buying a basket of perpetually changing TIPS, much like a bond fund. Due to special rules for ETF TIPS, the principal adjustments are distributed monthly along with the interest payments so this eliminates the phantom income problem mentioned above. For more information on this ETF TIPS go to www.ishares.com and look up the symbol TIP. If you prefer a mutual fund, consider Vanguard’s Inflation Protected Securities Fund (www.vanguard.com – symbol VIPSX). In 2004, it produced a respectable total return of 8.3% and charges an investor-friendly 0.18% management fee.
For fixed income investors who are concerned about the affect of rising inflation, TIPS are a security worthy of your investigation.
Next week, I will continue this discussion on how to inflation-proof your portfolio by reviewing alternative equity strategies.