Hedge Against Inflation and Deflation with TIPS

Treasury Inflation-Protected Securities offer a hedge against inflation and deflation.

According to TreasuryDirect.Gov, Treasury Inflation-Protected Securities, also known as TIPS, are marketable Treasury securities whose principal is adjusted in relation to fluctuations in the Consumer Price Index (CPI).  The general idea is with inflation the securities principal increases and with deflation it decreases.

As a definition, inflation is a general rise in the price of goods and services, such as food and clothing.  Due to this rise, it will take more money to buy the same goods and services – therefore eroding the overall purchasing value of money.  Inflation can negatively impact investors and savers as they lose purchasing power, and conversely help debtors as they’ll be able to pay back their debts faster with money that has lesser value.

Deflation is the opposite.  Deflation takes place when the general prices of goods and services fall over a prolonged time period.  The fall in prices allows consumers and businesses to purchase more with their money.  This sounds positive over the short-term, however over the long-term a continued fall in prices can negatively impact an economy.    If consumers believe prices will decline further, they will likely put off purchases, anticipating lower prices in the future.  A deceleration in demand will likely cause further price drops.  In turn, these declines will slowdown economic growth and likely affect the velocity of money in the economy – which can then lead to what is known as a deflationary spiral.

TIPS provide a hedge against these two precarious scenarios.  So, having a modest position in TIPS can be a good idea.

TIPS can protect investors from the effects of inflation.  Twice per year they pay a fixed interest rate that increases with inflation and decreases with deflation.  The interest rate is added to the adjusted principal.

One important caveat.  In a deflationary atmosphere, TIPS have what is called a deflationary floor that aims to protect a holder’s principal value.

TIPS can lose money during a deflationary environment.  It all depends on when the security is purchased.   Someone who purchases newly issued TIPS is assured they will receive the par value or the inflation-adjusted principal (the greater of the two) at maturity.   Those who purchase TIPS in the secondary market have to contend with securities that have been indexed higher for inflation, thus their security is farther away from the deflationary floor.  So these secondary TIPS buyers can lose money if prices fall.

Investors will not make a lot of money investing in TIPS, as they usually pay only a percentage point or two above inflation; but, an investor will preserve the purchasing power of their money five, ten and thirty years from today, which is ideal.

Rates & Terms for TIPS are issued in terms of 5, 10 and 30 years.  TIPS can be held until or sold before maturity.  The minimum purchase price is $100, while investment increments can be made in multiples of $100.  And of course the issue method is electronic.

For more information please visit www.TreasuryDirect.gov.

In all, for those who are nearing or in retirement, maintaining the buying power of their assets is paramount. Due to overall economic uncertainty, TIPS can serve as an important hedge in any long-term prudent asset allocation.