A Lesson from TIPS 16 comments
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WHAT ARE TIPS
While perusing the internet scrounging for investment vehicles I stumbled across an article suggesting Treasury Inflation Protected Securities (TIPS). With TIPS the government agrees to borrow FRN$’s at a specified interest rate. The creditor receives interest payments based upon the invested principal. Also, the government promises to adjust the principal periodically throughout the year to reflect the loss of purchasing power resulting from inflation during the period.
On its face, this appears like a safe and secure investment. The creditor receives modest interest income by lending capital to the government and are compensated for it and therefore do not bear the downside risk of devaluation through inflation. Surely many retirees must feel warm and fuzzy with this instrument that performs like a stock that pays both a cash and stock dividend. As the instruments are guaranteed by the venerable United States government, surely any investment advisor could recommend TIPS to anyone.
SNEAKY TRICKY GOVERNMENT
A deeper review reveals a dirty little government trick. But first a question. Assume 0% interest. If you invest $100,000 in TIPS for a year and the government declares the inflation rate to be 3% and after a year you redeem at $103,000; did you make an economic profit? Did you have a gain on your investment? Technically the government’s own decree is that you have not had economic profit. The TIPS principal is in the exact same economic position as a year earlier.
This is fine until you file your tax return and the government attributes to you $3,000 of taxable income. The less astute may not bat an eye as the government is simply doing what it does best, taxing you. The government concedes no economic profit because of inflation but still assesses a taxable gain.
If you assume a 25% tax rate, that would mean the government has managed to rob almost 1% of your purchasing power in just 1 year. Yet, no one complains because the amount of FRN$’s increased overall. Over 15 years the loss of purchasing power would be a slightly over 10% by investing in the very instrument the government asserts is designed to protect you.
NOT LIMITED TO TIPS
This scenario plays out in hundreds of examples where there is a taxable gain but an economic loss or loss of purchasing power. Real estate, stocks, bonds and commodities are all affected by inflation and investors get taxed through inflation without representation or due process of law. Have a 3% gain on real estate? Pay tax and end up behind. An 8% return on a stock portfolio? Well, 3% was courtesy of the government and now “the people” have the audacity to force you to give a share back.
Many assert that inflation is a tax. I partially agree. Theoretically in a predictable inflationary environment all assets rise together. Real estate, stocks, bonds and commodities all rise as the illusory currency evaporates. I am unaware of any government that permits concessions for currency debasement when taxing businesses and citizens.
This reveals the perniciousness of the inflation tax which results when there is either no economic gain or an economic loss yet taxation still results, it is unavoidable and pervasive. Even worse, the poor are most affected as they have no assets to rise with the illusory tide.
A gold ounce is an excellent example. In 2001 a gold ounce is purchased for $275. In 2008 the gold is traded for either $975 FRN$s or the equivalent amount of goods or services. The gain would be $700 even though the useless gold ounce did not change, grow or become scarcer in the world. Now the government demands a $200 share. Why?!?
Well, the government assert there is a gain and they want their cut whether they deserve it or not and are willing to use force to get it. Gold is especially painful because of the automatically higher tax rate which is instituted to make it less competitive as a currency in ordinary daily transactions. This is ansplendid reason to support sound money legislation like the Indiana Honest Money Act.
CONCLUSION
I am not among the gold bugs that assert gold is a perfect inflation indicator because I find that with the random volatility, or lack thereof in the 90’s, gold is too volatile in the short run. Nevertheless, in the long run, gold has been a great indicator of a competing currency’s value and is signaling that almost all are eroding fast. Even worse; all the governments are taxing businesses and citizens the entire way down during the great credit contraction.
This is a wonderful example of why businesses and individuals play tax games to reduce their exposure. But they are not the only ones. Who decrees the inflation rate used in the TIPS calculation? Yep, that same government that promised to adjust the TIPS so the investor would remain whole … before the taxes of course. There is surely no conflict of interest and people like John Williams of ShadowStats must be loony to assert that the inflation rate is understated. For these reasons TIPS are almost always an invitation, (not that they care to ask), from the government to steal from holders of capital.
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This recent SA article on TIPS notes that bond traders are beginning to "price in" inflation expectations:
seekingalpha.com/artic...
"The main reason for TIPS' recent popularity is that fixed-income traders are bracing themselves for government-sponsored inflation. Governments worldwide are starting to print a lot of money." Likely many TIPS buyers haven't considered Trace's outlook, but the expectations are building.
Government-sponsored inflation solves many more government problems than it causes,and that reason alone should be enough to warn investors about what's to come.
Larry
One thing to worry about is IRAs and 401ks. Those exist in their tax free status at the whim of the government. If the financial crisis demands that they be retroactively made taxable they will be.
Message is : be wary of any investment that depends directly on the US government setting the rules.
I think Amnericans need to throw a big party, we can call it the Boston Tea Party II.
inflation is a tax which the government (or a middle east oil potentate) places on your savings account and your life insurance policy.
in the 1920's weimar germany and hungary had hyperinflation.
due to today's economy, many people have no savings account, they live hand to mouth.
my $10K life policy purchased in 1962 covered over half a year's wages.
today it would cover my heirs' expenses for about a month.
> jack
I think you are being a little harsh on TIPS. They are a good diversifier for a "portion" of a diversified portfolio. You hit on the often cited negatives very well: taxation of inflation component and that CPI is not perfect inflation predictor.
Taxation of the inflation component is moot if you hold in retirement account or pension. It is also somewhat moot if TIPS are held in a mutual fund like VIPSX as they constantly have bonds maturing.
As for the CPI, true it is not perfect and probably understates inflation somewhat - what is the alternative? Presumably the market knows that the CPI is not perfect and the real rate demanded by the market builds in some level of skepticism about the calculation of the CPI. I think there are too many other indices tied to the CPI for the goverment to get too tricky...think about all the social security recipients and the wonderful lobby AARP! Maybe I am naive, but I have a small amount of trust in government, or at least know that too many people are affected by the CPI for it to be totally faked.
The good about TIPS for individual investors is that they can be easily bought without commission and if purchased as individual securities it avoids the ongoing expense ratio through a fund. They seem to be a no brainer over nominal treasuries...seriously who would buy a 10 year treasury for 2.8% nominal yield when you can get a TIP for 1.8%. If you think inflation (even the allegedly cooked CPI is going to be less than 1% per year over the 10 years...go buy that nominal treasury bond.) The US government guarantees that you will get 100% of your principal back even in the event of prolonged deflation when the bond matures. There is also no credit risk to TIPS, unless you are one of those people who really think the feds will not pay their obligations...if so go buy guns and butter.
They are a dollar denominated security, so yes they suffer consequences with a falling dollar...but so do all dollar denominated securities. That is not a criticism of TIPS per se.
TIPS are good (but not perfect) investment to ladder as a small part of a diversified portfolio in my opinion. I would say TIPS could be used up to 10 or 20 percent of a portfolio - depending on someone's fixed income allcoation. If you can lock in a real TIP yield at 2.5% or higher, maybe even a larger portion of a portfolio. Just my two cents.
>" Message is : be wary of any investment that depends directly on the
> US government setting the rules."
In that case that would be "all investments!
The poignant part to is focus on this simple study of how it is the government is able to steal from its citizens through inflation. TIPS (in non-tax advantaged plans) are an excellent demonstration of how this is accomplished. Gains recognized only through inflation result in economic losses thanks to the people who inflated the dollar in the first place.
Republicans have tried to float an idea of a capital gains tax system where inflation is backed out of the gain calculation. It sounds good in theory but would very difficult to administer.
Omooc asked what is a good inflation hedge? TIPS are not perfect, nor is gold, real estate... but they are better than long/intermediate term nominal bonds thats for sure if inflation heats up. If Obama does not do away with the unlimited ROTH conversion in 2010, that could be a good idea for individual investors. It could help resolve the income tax problem with the taxation of future inflation and higher tax rates which may be coming down the road in years to come. (This assumes the feds will truly not tax ROTH distributions...but that is another conversation).
-The principal adjustment protects your income stream from inflation
-They can't be adjusted below their initial purchase price
-TIPs should be held in a tax free account, if you have money to invest outside of an IRA/401k of course don't buy TIPs or any taxable bond.
I've been buying them up lately and doing quite well so far. This is another typical SA article that's more about predicting doom than giving any useful investing advice.