Treasury Inflation Protection Securities (TIPS) are government-issued, marketable securities designed to provide protection against inflation. TIPS are bonds that have a principal amount, a set interest rate and offer a specific yield.
The principal amount of TIPS is adjusted based on changes in one of the measures of economic trends: the Consumer Price Index (CPI). With a rise in the CPI (inflation), the principal increases. With a drop in the CPI (deflation), principal decreases. At maturity, owners of TIPS receive either the adjusted principal or the original principal, whichever is greater—which is how buyers are protected against deflation.
Based on how these securities work, TIPS should outperform Treasuries if inflation is higher than expected and under-perform Treasuries if inflation is lower than expected.
Inflation, to put it in a very simple way, is a rise in the general level of the prices of goods and services in an economy over a specific period of time. When the general price level rises, dollars buys fewer goods and services and, as a result, consumers have less purchasing power because many of the things they buy are more expensive.
Are we in inflationary times? The fear that we are has escalated for a number of reasons: the hope of an economic recovery, the government’s printing of money due to the stimulus plans, and recent talk of a second stimulus plan. In addition, we have high unemployment, unused industrial capacity, higher oil prices and a fall in the U.S. currency. Does it sound like inflation to you? Should you be buying TIPS or a TIP Bond Fund to hedge against inflation?
Dr. David Kelly, Managing Director and Chief Market Strategist at J.P. Morgan Funds, says we are not yet in inflationary times. The single most important factor determining U.S. inflation, according to Kelly, is employee compensation. With high unemployment, wage growth is unlikely. The U.S. deficit alone cannot cause inflationa deficit with an economy running at full capacity is the chief cause of inflation. We are not running at full capacity, and oil prices are actually deflationary in our economy.
We may experience inflationary times with a deficit over a trillion dollars, a second stimulus plan being proposed and there are signs of a healthy economic recovery. Confused about TIPS as an inflation hedge? Talk to your Moneta Family CFO to decide whether or not TIPS makes sense for your portfolio.