Treasury inflation-protected securities

The drop in gasoline prices is one factor that has kept overall inflation muted. Here, gas prices at a service station in New Jersey last week. Associated Press

Last week, Jason Zweig offered a tip to buy more TIPS .  The drop in prices of these Treasury inflation-protected securities has left them at reasonable levels, he suggested, and they are designed to become more valuable when inflation heats up.

While TIPS indeed provide some protection against inflation, investors will actually make more if inflation is low.  Allow me to explain.

Reframing Fixed Income

Before I make my case, it’s important to understand both what money is and the role that fixed income should play in your portfolio.  First, money is merely stored energy that gives us the power to provide for our wants as well as our needs and to pursue happiness.  We can’t take it with us.  So rather than assume the role of fixed income is to provide income, I would argue that the role of fixed income is to act as the stable store of this energy.  (Stocks are the growth portion of the portfolio.)

To better illustrate the illusion that bonds provide income, you may think that interest rates are at an all-time low.  I couldn’t disagree more.  See, in 1980, one could earn 12% on a 10-year Treasury note, and most people wish those times would return.  The hitch was that, after taxes, the return was about 8%, and inflation was about 13%, meaning investors lost about five percentage points in spending power.

What truly matters is our real return after inflation and taxes. With TIPS, the bond’s principal value and interest payments to investors go up along with inflation. If we accept the fact that money is stored energy to support our desired lifestyle, then we must accept the fact that TIPS are the most stable of all investments.

If the economists are wrong (yet again) and inflation rises more than expected, then a fixed-rate Treasury bond will provide less real spending power.  On the other hand, if deflation roars its ugly head, fixed-rate Treasury bonds will do great.  But if you accept the fact that no one knows future inflation, then TIPS clearly have less risk and provide more stable spending power.

Why TIPS Are Better With Low Inflation

To grasp why TIPS yield more if inflation is low, we must remember that the federal government taxes us based on nominal income.   Jason Zweig noted last week that the average real (that is, after-inflation) yield on TIPS is now about 0.5%.  Should the Federal Reserve hit its 2% inflation target, then the nominal yield will be about 2.5% (2% inflation plus 0.5% real yield).  If you are in the 33% marginal tax bracket, you will earn about a 1.67% after-tax nominal yield, or lose about 0.33% in spending power (1.67% less inflation at 2.0%).

Now let’s look at higher and lower inflation.  If inflation averages 4%, then TIPS provides a 4.5% nominal pretax income, or 3.01% after-tax nominal yield.  Subtract out the 4% inflation and the real yield is a loss of 0.99%.  But, if inflation turns out to be zero, you get a 0.5% pretax return, or 0.34% after tax.  With no inflation, your after-tax real return is a positive 0.34%.

You may argue that this doesn’t work for TIPS in individual retirement accounts or 401(k) accounts.  First and foremost, one must understand that the dollars in these accounts (except for Roth accounts) are tax-deferred rather than tax-free, so eventually taxes will be paid.

Next, since TIPS are exempt from state tax, they are usually best held in taxable accounts.

My Tip on TIPS

I consider my TIPS to be the most stable store of spending power in my portfolio.  I know I don’t know what inflation will be, and neither do the economists.  I don’t buy or sell based on speculation.  TIPS will likely become hot with high inflation expectations, and as cold as an Arctic vortex with low inflation expectations.  Setting consumer perceptions aside, your store of real after-tax spending power is actually greater with low inflation.  So avoid the herd that will likely buy high and sell low and consider TIPS as a long-term strategy to protect your real spending power.  That’s my tip on TIPS.

–Allan S. Roth is the founder of  Wealth Logic , an hourly-based financial-planning firm in Colorado Springs, Colo. His contributions aren’t meant to convey specific investment advice.