In June, the Federal Reserve confirmed that only some of the inflationary price pressures we’ve been witnessing are transitory, and it may need to move up interest rate increases, though likely not until 2023. As investors, we will need to look even harder for ways to grow portfolios in order to retain our purchasing power, but also treading carefully in order to not take on too much risk by doing so.
One way to manage risk in a portfolio is through asset allocation, the balancing of stocks and bonds. With a potential increase in interest rates coming, this strategy should be considered more carefully in terms of one’s time horizon. Should interest rates rise, on paper the value of existing bonds will fall, that’s just how the bond math works. However, if held to maturity the bond principal is not affected.
A more direct approach is investing in Treasury Inflation-Protected Securities, or TIPs. They’ve been provided by the U.S government for over 20 years, and their value is tied to changes in the Consumer Price Index (CPI).
CPI-linked returns
These securities are issued in maturities of 5, 10 and 30 years. The principal value of the TIPS is adjusted annually for inflation, and that, in turn, affects the semiannual interest payments. Although inflation won’t remain constant for the term of the TIPS, we can understand this through a simplified example: let’s assume a $10,000 bond, inflation at a constant rate of 2.5%, and that the bond pays a 2% dividend rate semi-annually for 10 years (1% twice during the year). In the first year the bond will pay $200 in dividends for the year, and at the end of the year it will be adjusted to a face value of $10,250. The dividends the next year will increase because of the change in the face value, to $205. By year 10, the bond value would be $12,800 with the coupon payments being $256 for the year.
How are TIPS traded?
TIPS are traded on the secondary market. Their price fluctuates with changes in interest rates as well as changes in the inflation rate. TIPS at times have been even more sensitive to interest rates than conventional bonds. Given this potential volatility, they may be better suited to longer time horizons, and a good choice for IRAs.
Some investment funds include TIPS among their holdings, and some funds specialize in TIPS. Funds can provide for diversification of maturities. However, funds do not have a maturity date, and so can present risks not present when TIPS are owned outright.
Tax considerations of TIPS:
The coupon payments from TIPS are subject to ordinary income tax.
The principal adjustment is subject to ordinary income tax as well, in the year that it is made, though there is no cash distribution to draw the tax payment from, so one should take care to reserve cashflow for that income tax. In the example above, when the value of a $10,000 bond is raised to $10,250 to account for 2.5% inflation, that $250 adjustment is fully taxable even though it won’t be paid until maturity. One way to avoid the cash flow problem with these valuation changes would be to have the TIPS in a tax-deferred accounts, such as an IRA.
In the event of deflation, the value of TIPS will decline. However, the redemption will be at face value, and the dividend can’t fall below zero, so there is a deflation hedge built in as well.
Other ways to position your portfolio for inflation
Some investors favor different strategies for ensuring they retain their purchasing power. Notable alternatives might be dividend-paying stocks or particular sectors such as commodities.
The longer the bull market continues, the more expensive stocks become compared to their earnings, and the more difficult it is to find “undervalued” stocks. On the other hand, should company earnings continue to rise, current valuations may be justified. Historically stocks as a whole have outperformed inflation, so they may be a good hedge against inflation themselves. In the last ten years, growth stocks have outperformed value stocks, but value stocks have outperformed growth stocks in the first six months of 2021, so investors may be looking to solidify their holdings in companies with more historic stability and lower P/E ratios.
If you would like a second opinion about your portfolio management strategies, setting up a meeting with an Arvest Wealth Management Client Advisor is easy, and has no pressure or obligation attached to it.
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