“Changing inflation expectations may cause your adviser to recommend TIPS. But he must know that they do not work like conventional bonds and can carry more risks.” — Chief Lyle
Treasury Inflation-Protected Securities (TIPS) are securities issued by the United States Treasury. TIPS are indexed for inflation to offer investors protection against a decline in the purchasing power of their dollars. When inflation rises, TIPS will adjust in price to maintain their value.
Although TIPS work in a similar way to conventional bonds, they are missing an essential component in the form of collateral. TIPS are not guaranteed investments. Because they are unsecured, even though they are indexed for inflation, their value may not increase during an inflationary period.
As with other stocks, TIPS moves more with investor expectations than inflation reality. Relying primarily on expectations means that TIPS are more likely to outperform regular bonds if the actual rate of inflation turns out to be higher than expected. If inflation turns out to be lower than expected, TIPS may underperform conventional bonds.
Some people turn to TIPS and mutual funds that invest in TIPS to protect their portfolio. They can be a good choice when inflation is high, as they offer stability and relatively low market risk, while other securities may not. Investing in TIPS is often seen as more of a short-term strategy.
What are the pros and cons of TIPS?
TIPS have two main benefits:
TIPS Offer Low Market Risk: Because they are US government-backed Treasury bonds, TIPS offer somewhat less investment risk than other types of investments. TIPS have low inflation risk: Since they are indexed for inflation, TIPS have almost no inflation risk as long as an investor’s “personal inflation rate” is close to the consumer price index (CPI).
However, TIPS are not without risks. The most critical of these are:
The possibility of price fluctuation exists: TIPS are low-risk investments, so their market prices can change substantially when real interest rates change. Therefore, the share price of a mutual fund that invests in TIPS can vary significantly in the short term. There is a risk of deflation: Deflation is the risk of a general fall in prices deflation. It is the opposite of inflation. In a long period of deflation, TIPS could lose some value.
Could annuities be a better option than TIPS?
Both annuities and bonds are part of the “fixed income” asset class. Since bonds are market-traded, investors have traditionally used them most often when building the “safe money” portion of their retirement portfolios.
However, several retirement planners have recently begun moving their clients away from bonds and into annuities. A growing body of data, including papers produced by prominent retirement researcher Wade Pfau, indicates that the most efficient retirement portfolios have stocks and annuities, but not bonds. According to Pfau, this combination best addresses retirees’ top retirement goals: not running out of money and leaving a legacy for loved ones. Pfau believes that because annuities offer “mortality credits,” they will outperform bonds and bond funds over the long term. Pfau’s research also points to the possibility of having more significant liquid financial assets later in retirement by investing some of your money in annuities.
TIPS or TIPS funds can be a good addition to a diversified portfolio for some early retirees and retirees. But even though TIPS are a type of fixed income investment, you should be aware that they don’t work the same way as corporate bonds. Annuities are another possibility, especially if you’re worried about having enough money for retirement or want to create a legacy. Talk to a Certified Financial Fiduciary (CFF) about all of your fixed income options before making any decisions.
Lyle Boss is a member of the Syndicated Columnists, a national organization committed to a fully transparent approach to money management. Boss Financial, 955 Chambers St., Suite 250, Ogden, UT 84403. Phone: 801-475-9400.
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Source: www.standard.net