Close-up: Treasury Inflation-protected Securities

Physician's Money Digest, September 2006, Volume 13, Issue 9

n.

Treasury Inflation-protected Securities: US government-issueddebt securities similar to regular savings bonds except that they offer aninvestor inflation protection.

Treasury Inflation-protected Securities (TIPS) havebeen available from the US Treasury since 1997.Because they are backed by the government, theyare an exceptionally low-risk investment, offering virtuallyzero default risk and inflationary risk. TIPS usually featuresome of the lowest rates of return, but because theyare usually exempt from income tax, they also provide amore attractive after-tax return. The government issuestwo types of inflation-protected securities: TIPS and USSavings Bonds (I-Bonds). Both, according to theInvestment U Web site, work in a similar fashion. Interestpayments are made twice a year and are linked to the consumerprice index. Essentially, investors receive a guaranteedinterest rate plus an amount equal to the currentinflation rate.

The Real Deal

In a very real sense, TIPS are a form of insurance. It'soften said that the optimum time to purchase insurance iswhen you don't need it. It's a little late to purchase automobileinsurance after you've been in an accident. Thesame holds true with TIPS. Granted, inflation has been relativelyunder control in recent years, but now might be thetime to consider purchasing TIPS.

Money

The value of inflation-protected securities is illustratedby an example posted on the www.finpipe.com Web site.The example compares a normal 10-year Treasury bond toan inflation-protected security. At the time of the posting,the 10-year Treasury was yielding 6.4%. However, inflationat that time was 3.3%. Investors in the 10-year Treasurywere faced with a bottom-line yield of 3.1%. At the sametime, the yield on an inflation-protected security was3.3%, or 0.2% higher than the yield of the Treasury. If youwant to think in more present terms, an article in magazine suggests that this is a good time to invest in IBonds.These inflation-protected savings bonds are currentlypaying a fixed rate of 1.4%, the biggest premiumover inflation in 3 years.

Another History Lesson

Investment U

Writing in an bulletin from December 30,2002, Dr. Steve Sjuggerud points out that "there is onlyone type of investment that is truly guaranteed and willalways absolutely keep up with inflation and pay you apositive return on your money." Of course, he's talkingabout TIPS. In addition to purchasing TIPS or I-Bondsdirectly from the government, another option is to investin a fund similar to Vanguard's inflation-protected securitiesfund. The fund could, theoretically, lose money briefly,Sjuggerud writes, but he offers an eye-opening example ofthe value of TIPS.

According to Sjuggerud, the Vanguard mutual fund ofinflation-protected securities opened in mid-2000 andreturned 6.02%, 7.61%, and 15.82% each year throughthe end of 2002. He points out that $100,000 invested inthe fund at its inception would have been worth morethan $132,000 at the end of 2002. In contrast, the same$100,000 invested in the Nasdaq at that time would beworth approximately $34,000. I-Bonds are good for up to30 years, but be aware that they cannot be redeemed for1 year. So if you think you might need to make use of thefunds, they might be better off in a short-term money marketaccount or CD.

Can't-lose Proposition

There has been much discussion about howinflation-protected securities are a sure betagainst inflation. Since I-Bonds are now paying afixed rate of 1.4% over inflation, investors willalways be 1.4% ahead of rising prices. If inflationjumped to 10%, physician-investors realize 11.4%in real returns.

However, there's no penalty on the flipside,and that's one of the nice things about inflation-protectedsecurities. If inflation suddenly dippedto -5%, investors don't lose. They still receive thecurrent interest rate, which today is 1.4% on IBonds,and are not compensated for inflation,because there was none.

In effect, with TIPS, investors will never losethe principal of their investment, and will alwaysstay at least a percentage point or two ahead ofinflation. There are no free lunches, but there certainlyare risk-free investment options.

POP QUIZ

1) TIPS stands for

  1. Treasury Inflation-protected Securities
  2. Tobacco Information and Prevention Source
  3. Training for Intervention Procedures
  4. None of the above

2) There are two types of inflation-protected securities,TIPS and

  1. H-Bonds
  2. K-Bonds
  3. I-Bonds
  4. James Bonds

3) I-Bonds are currently paying a fixed interest rate of

  1. 1.2%
  2. 1.4%
  3. 1.6%
  4. 1.8%

4) Inflation-protected securities are generally exemptfrom income tax. True or false?

  1. True
  2. False

5) I-Bonds cannot be redeemed for a period of

  1. 3 months
  2. 6 months
  3. 12 months
  4. 18 months

Answers: 1) a; 2) c; 3) b; 4) a; 5) c.