This is an oversimplified case study to introduce you to an investment that you have all heard of, but may not understand because of its complexity – and it is very complex.
The investment problem is INFLATION. One investment that is designed to protect against inflation has the nickname of TIPS. The formal name is Treasury Inflation-Protected Securities.
There are many articles that describe how TIPS work in detail including the presentation that we have made in our book entitled Bonds: The Unbeaten Path to Secure Investment Growth, 2nd edition at pages 114-120.
The case study that we present below is designed to help you take the first step in an analysis of whether you might buy TIPS rather than Traditional Treasury bonds (Treasury) if you are very concerned with inflation.
Our Case
Our client Bob is a conservative high net worth investor. He is soon to be retired and will be living on income from his portfolio which includes a large allocation to bonds.
Bob is very concerned about inflation and asked whether an investment in TIPS would better protect him from inflation than traditional Treasuries. Our conclusion in the case below is: MAYBE.
We did our research on September 25, 2024 and found the following facts comparing a Treasury to a TIPS bond:
Treasury bond: 3.875% coupon due 8/16/34, price 100.765 has a yield-to-maturity of 3.78%.
TIPS bond: 1.750% coupon due 1/15/34, price 101.221 has a yield-to-maturity of 1.61%.
Analysis
The prices are similar, but the Treasury coupon (and the yield-to-maturity on the Treasury) is more than twice the size of the TIPS coupon: 3.87 – 1.75 = 2.12%. However, that is not the end of the analysis. Here we get technical.
Let’s simplify the math so you can see the concept. Assume a 100 Treasury bond. The Treasury coupon is fixed so that it pays 3.875 every year.
The return on the TIPS consists of two parts:
It has a coupon of 1.75% so it initially pays 1.75 per year. In addition, the value of the TIPS principal increases periodically at a rate of inflation based on the consumer price index for all urban consumers (CPI-U).
Here is a way to compare the Treasury and the TIPS:
Return on the Treasury: 3.87
Return on the TIPS: 1.61
Difference: 2.26
Conclusion
If you believe that the inflation rate for the next 10 years will average significantly more than 2.26%, you might consider the TIPS. If not, go with the Treasury.
Disclaimers: This is an over simplified example of a very complex subject. However, it was presented to provide a basis for the beginning of an analysis of when it might be advisable to consider an investment in TIPS.
©Hildy Richelson and Stan Richelson September 30, 2024