They were given the lofty moniker “Treasury Inflation-Protected Securities”, or TIPS, by the US government when they were first launched in 1997. But the timing of their “birth” was curious in that it came years after inflation last posed a serious threat in eroding the value of financial assets.
Even so, TIPS have been very popular since their creation in that they are backed by US Treasury securities, so were an ultra safe investment that was made even better in many investors’ eyes because their returns were linked to changes in the Consumer Price Index (CPI). In TIPS, the investor’s real rate of return, which represents the growth of its purchasing power, is guaranteed. The downside is that, because of this safety, TIPS offer a low return.
Now comes 2004. By all measurements, inflation is on the rebound and that could attract even more investors to believe that TIPS are the answer for their portfolios.
On the surface, these securities still look like a safe bet for those investors concerned about building in an interest-rate hedge strategy. But, a second look will reveal more than a few blemishes on these ultra-trendy fixed income instruments, says Susan B. Fulton, Managing Director and co-founder of Fulton Breakefield Broenniman, a firm which caters to high net worth investors, employing customized portfolios.
“TIPS were conceived as a security that could offer a fair interest rate for its duration and protection of purchasing power by tying the value of the security to the CPI. But, two factors – the popularity of the securities and political considerations – have combined to put both assumptive benefits at risk,” says Fulton.
The Treasury has found that they can offer a “lower than duration rate” on TIPS without seeing demand for the securities drop. According to Fulton, this has been enabled by the mainstream touting of TIPS and investors’ assumption that TIPS will indeed grow in value to preserve purchasing power when they mature. Thus, we’ve seen the Treasury price the most recent batch of 10 year TIPS at a current yield of 2.5%, far below the yield on 10 year treasuries that are not TIPS.
“More crucial to the situation are the political considerations that have put inordinate pressure on Congress to lower the CPI by 1.1%,” asserts Fulton. “With the federal deficit just under $900 billion and Social Security facing the baby boom generation that will be lining up for checks soon, the benefits of lowering the CPI will likely be too good for Congress to pass up. By lowering the CPI, Congress would effectually lower the growth of social security payouts and decrease the cost of borrowing using TIPS – thus, Uncle Sam could have his cake and eat it too!”
The Treasury’s recent announcement that it will be offering TIPS in the 5, 10 and 20 year categories comes as no surprise to Fulton. While the Treasury is looking to capitalize on the popularity of TIPS, investors should be prepared to take a hit if they invest in them. If Congress does indeed “recalculate” the CPI, then TIPS investors will not only see the value of their investment plummet, but they will not get the purchasing power protection that may have attracted them to TIPS in the first place, she points out.