Ten TIPS to Tip Inflation in Your Favor

Ben Bernanke keeps saying the Federal Reserve will do “everything it can” to encourage economic growth. But his first two “quantitative easing” programs were no help for average Americans. They were very beneficial for Wall Street, though, so the big banks want more.

Meanwhile, Congress and the White House are locked in a no-win battle over government spending. Yet even the most hawkish politicians are proposing only minor cuts. Everyone knows the big enchiladas — Social Security, Medicare, and so on — are off the table.

Many analysts think inflation will be the inevitable result. Maybe so, maybe not. But it doesn’t hurt to think about the possibility.

Back in February I gave you 4 Ways to Fight Inflation with ETFs. One of those ways was with Treasury Inflation-Protected Securities, TIPS bonds. And today I want to zero in on some ETFs that hold TIPS. These instruments are widely misunderstood but may be amazingly useful if inflation gets out of hand.

First, let’s step back. Exactly what is “inflation,” and why is it a problem?

Inflation in Your Shoes

Economists can give you hundreds of fancy definitions. Here’s the way I see it: Inflation is a loss in the purchasing power of money. A given amount of money no longer buys as much as it did it in the past.

Here’s an illustration: Suppose you have $100. You want a nice pair of shoes that you saw in a store window, but you decide to wait.

Are your shoes shrinking — or your dollars?

A year later, having decided you really like those shoes, you bring your $100 and come back to buy them. Unfortunately, the intervening year had a 5 percent inflation rate. The same shoes now cost $105.

Looking at it another way … the shoes cost the same as before. What really happened is that each of your dollars is worth 5 cents less. In any case, you’re $5 short. Your choices are to either a) do without the shoes, or b) come up with another $5 somewhere.

Now, if you had known a year ago that your $100 would shrink 5 percent, the ideal solution would have been to spend it as soon as possible. Shoes turned out to be a better investment than cash for that year.

Multiply this scenario for everything else you buy: Food, clothes, housing, fuel, whatever. Inflation punishes saving and rewards spending.

This is why bond investors are particularly vulnerable to inflation. When you buy bonds, you are a lender. Even if your interest income actually goes up in nominal terms, your investment is still losing ground.

And that’s where TIPS can come in handy.

TIPS for Inflation

The U.S. Government issues a special kind of bond called Treasury Inflation-Protected Securities, or TIPS. Unlike regular T-bills or T-bonds, TIPS have a built-in inflation adjustment.

Remember these?

Remember when retirees used to get a COLA every year? The “cost of living adjustment” is tied to an inflation benchmark, typically the Consumer Price Index. It hasn’t happened the last couple of years because CPI was flat.

TIPS have a similar goal. If inflation goes up beyond a certain point, the principal value of TIPS bonds is automatically adjusted to compensate. In theory this keeps TIPS holders from losing purchasing power while they own the bonds.

The inflation adjustment isn’t free however. You must be willing to accept a lower initial yield while waiting for a boost from inflation.

Now if you genuinely expect very high inflation and want to aggressively capitalize on it, gold or other commodities may be preferable for you. Conservative and income-oriented investors are the target audience for TIPS.

As with other bond categories, you can buy individual TIPS issues. Doing so can be costly and impractical in small amounts, though. Low-cost ETFs are a much better way in most cases.

With TIPS ETFs, you can easily adjust your investment when needed. You can get diversified exposure to many different maturities in one easy transaction.

Here are some ETFs currently available to U.S. investors that invest exclusively in U.S. Treasury issued TIPS:

• SPDR Barclays TIPS ETF (IPE)
• PIMCO 15+ Year U.S. TIPS Index Fund (LTPZ)
• Schwab U.S. TIPS (SCHP)
• iShares Barclays 0-5 Year TIPS Bond Fund (STIP)
• PIMCO 1-5 Year TIPS Index Fund (STPZ)
• iShares Barclays TIPS Fund (TIP)
• PIMCO Broad U.S. TIPS Index Fund (TIPZ)

These ETFs include TIPS from other countries:

• SPDR DB International Government Inflation-Protected Bond (WIP)
• iShares International Inflation-Linked Bond (ITIP)
• iShares Global Inflation-Linked Bond (GTIP)

By the way, if you invest through Charles Schwab, you may be able to buy and sell SCHP without a transaction fee. Fidelity investors can do the same with TIP. Nice!

Are TIPS a foolproof answer to inflation? No, I’m afraid not. They can be a valuable component of a retirement income strategy, but they shouldn’t be the whole strategy. Plan ahead, and include TIPS as one of your possibilities.

Best wishes,

Ron

P.S. I included ETFs that invest in TIPS from other countries because if you’re investing only in the U.S., you’re investing with one hand tied behind your back! Click here to learn why.