Key learning points
- With traditional bonds, you pay a nominal amount and earn a fixed rate of interest over the life of the bond.
- Treasury Inflation-Protected Securities (TIPS) also have fixed interest rates. However, the face amount adjusts based on inflation, which can increase or decrease your interest payments.
- Buying TIPS outright gives you the most control and helps limit losses compared to buying a TIPS mutual fund or exchange-traded fund.
With inflation rising, many investors are looking for ways to earn returns that keep pace with inflation. While the options may seem limited, one option that is gaining popularity is Treasury Inflation-Protected Securities.
Here’s how this investment works and helps protect your wealth in times of high inflation, and how Q.ai can help you do just that.
What are inflation-protected securities?
Treasury Inflation-Protected Securities (TIPS) are US government bonds that pay interest based on current inflation. They are an excellent place to put in cash because the federal government backs them.
TIPS also help investors diversify their portfolios, provide a guaranteed return on their investment, and have the potential for higher returns compared to savings bonds or other types of government bonds.
How do TIPS work?
To understand how TIPS works, it is crucial to understand how a regular bond works. When you invest in Treasury bills, bills or bonds, you buy in increments of $100. They mature in different time frames (from four weeks to 30 years), have a fixed interest rate and pay semi-annually.
If you were to buy $1,000 worth of bonds maturing in 20 years and pay 5% interest, you would make $50 a year, or $25 every six months, for 20 years. When the bond matures at the end of 20 years, your $1,000 principal will be paid back to you.
TIPS nominal value
Investing in TIPS is slightly different because the face value of your investment changes based on inflation.
Suppose you bought $1,000 worth of TIPS that mature in 20 years and have an interest rate of 5%. Moreover, let’s say that inflation eventually rises by 5%. In the beginning, you would make $50 a year or $25 every six months.
However, once the bond is adjusted for inflation, the TIPS principal is now $1,050.
Your interest rate of 5% is fixed for the whole of the bond. But as the principal has increased, your interest payments increase because 5% of $1,050 is more than 5% of $1,000.
It is essential to also understand that if deflation is present, the TIPS principal may fall below the purchase price.
TIPS interest rates
The principal amount of TIPS is based on the current rate of inflation as indicated by the consumer price index (CPI).
The last opening auction for TIPS took place on 10/20/2022 and the interest rate for a five-year security was 1.625%. By comparison, the auction of a five-year Treasury bill on October 31, 2022 had an interest rate of 4.125%.
Although the interest rate on the Treasury Note is higher, the TIPS investment can yield more if you expect inflation to remain high or rise over the next five years, due to the principal adjustments.
Sell your TIPS investment early
It is possible to sell your TIPS investment before it matures. However, you may not get the principal you paid if you do this.
As interest rates for newly issued Treasuries vary, the principal of older Treasuries will also differ as they may be in more or less demand depending on the interest rate.
If your Treasury has an interest rate of 2% and new Treasuries have an interest rate of 6%, you will have a hard time selling it at face value. Investors would rather pay the same price for a newer Treasury and earn a higher interest rate. The result is that you have to sell at a lower price.
The opposite is also true. If your Treasury has an interest rate of 6% and newly issued Treasuries pay 2%, you will get more than the principal if you decide to sell it. Again, this scenario only applies if you sell your Treasury before it expires.
How TIPS protect money during a recession
TIPS allows you to park your money during a recession and help preserve its value. The face value of TIPS goes up or down with inflation or deflation.
During a non-inflationary period, your investment earns the interest offered at the time of purchase. When inflation spikes, the principal of a TIPS increases, meaning you’re paid a higher interest rate every six months.
This will help protect you if inflation gets higher. If you were to invest in a government bond, you would have no protection against higher inflation. The interest payments you earn are the same every year for the life of the Treasury.
The only way to get a higher return to potentially keep up with inflation is to sell your current holdings and buy new Treasuries with a higher interest rate.
TIPS are sold directly through the government on the TreasuryDirect website. The minimum purchase is $100, and TIPS are available in $100 increments. You can purchase them in five, 10, or 30-year installments.
Another option is to buy TIPS through an exchange-traded fund (ETF) or mutual fund. Buying TIPS through a fund offers more control over your money as you have more liquidity if you want to sell before maturity, but this option also incurs brokerage fees.
The other thing to keep in mind when buying TIPS through a fund is that the fund usually doesn’t last until maturity. Since these investments pool investors’ money, the fund must sell some positions if some investors want to sell before the TIPS expire. Depending on the economic environment, this could result in you losing money.
To have complete control over your investments, your best option with regard to TIPS or any bond is to own them directly and not through mutual funds or exchange-traded funds.
it comes down to
TIPS are a smart option for keeping up with rising inflation and investing during a recession. With traditional bonds, you are locked into a fixed rate of return over the life of the bond. With stocks, you are at the mercy of the entire market.
With TIPS, you get a fixed interest rate with a nominal value that adjusts for inflation. This can provide more stability, taking into account the economic climate.
Another solution is to use Q.ai’s Inflation Protection kit. It uses the power of artificial intelligence to spot trends and invest in assets that are expected to hold their value in times of inflation. It’s a great alternative that simplifies your investment strategy.
Download Q.ai today for access to AI-powered investment strategies.