Among all the different types of investments available these days, U.S. Treasury securities – and funds investing in them – are the only ones considered risk-free. An allocation to Treasuries helps mitigate overall risk. But there are two different types: Treasury notes/bonds and Treasury Inflation-Protected Securities (TIPS). Which should you use?
TIPS and Treasury notes/bonds are issued by the U.S. government in maturities of five, 10 and 30 years (Treasury notes additionally come in two-, three- and seven-year maturities). Both have fixed interest rates that are paid semiannually. The biggest difference between them is that TIPS provide protection against rising inflation. This is accomplished by annually adjusting the principal of a TIPS bond based on changes in the Consumer Price Index for All Urban Consumers (CPI-U).
It’s easiest to understand by example. Suppose you purchase a $1,000 TIPS with a 2 percent coupon. You will receive $20 per year in two semiannual payments. Suppose also that by the end of the year the CPI-U has increased by 3 percent. The principal will be increased to $1,030 and the following year’s payments will total 2 percent of $1,030, or $20.60. This process repeats each year until the bond matures, at which time you’ll receive the higher principal. In the uncommon situation where the CPI-U drops because of deflation, the principal will never drop below the original face value ($1,000)
At first glance, this sounds like a no-brainer. If/when inflation rises, you not only get a higher annual payout, but you also get more money back when the bond matures. However, consider the following:
• While Treasuries and TIPS are taxed each year on the interest payments, TIPS are additionally taxed on any increase in the price of the principal.
• The principal prices of both types of bonds fluctuate daily based on prevailing interest rates (which are not necessarily aligned with the inflation rate as measured by the CPI). An increase in rates causes a decrease in the value of the principal and vice versa. If you are investing in TIPS through a mutual fund or exchange-traded fund, it’s possible for interest rate fluctuations to impact the value of the fund’s share price more than inflation.
Treasuries or TIPS?
If you want to add a safe investment, how do you decide between them?
The easiest way is to base the choice on your expectation of future inflation. First, calculate the market’s breakeven rate (the difference between the current Treasury bond yield and TIPS yield for the maturity you are considering). For example, as of this writing the five-year Treasury bond is yielding 2.3 percent and the five-year TIPS stands at 0.52 percent. The breakeven rate is therefore 2.31 percent - 0.52 percent = 1.79 percent.
If you believe the inflation rate is likely to rise higher than 1.79 percent over the next few years, then you should invest in the TIPS bond or in a TIPS fund of similar maturity, because either would be expected to provide the higher return.
Keep in mind that returns on both TIPS and Treasuries are relatively low right now. There are many other types of bonds generating higher returns. Keeping the fixed-income portion of your portfolio well diversified beyond Treasury notes/bonds and TIPS – particularly if you are approaching or are past retirement – can be even more important than diversifying the equity portion.