U.S. Treasury securities have traditionally been considered the safest investments in the world. They are, after all, backed by the “full faith and credit” of the U.S. federal government, a safety net unmatched by any other investment. A company, regardless of its age, size, or reputation, can always fall, sometimes dramatically and unexpectedly. It’s easy to forget that Enron, prior to the financial scandal that led to its bankruptcy in 2001, was a major American corporation, held up as an example of good management. Highlighted multiple times by Fortune as the country’s most innovative company, Enron was dealing in what had been considered a relatively safe foundational part of the economy: electricity, natural gas, and communications. Within a matter of months the $100 billion a year company was no more.
Today, however, with the U.S. and global economy facing a financial crisis like none in history, even the best reputations are being re-examined. The unprecedented levels of current and anticipated debt have raised fears that politicians will ultimately look for a back door exit, giving the green flag to economic policies that will drive inflation, making it easier to pay off old debts with cheap paper. The notion that high inflation rates favor debtors is an old one, and desperate governments have been known to use it, but it’s the fear of inflation, not inflation itself, that has become a factor in such conservative investments as U.S. Treasury securities.
But not all Treasury securities are the same. There are basically four types of treasury securities. First there are Treasury bills, Treasury notes, and Treasury bonds. Treasury bills are purchased at a discount, maturing in one year or less, with no interest paid in between. Treasury notes can be for up to 10 years, but give a coupon payment every 6 months, based upon a fixed coupon interest rate. Treasury bonds often last up to 30 years, and also have a fixed interest coupon payment. Obviously such fixed return investments face the risk of inflation.
Then there are TIPS (Treasury Inflation Protected Securities). TIPS are long term securities, maturing in 5, 10 or 30 years, with a coupon interest rate that is also fixed. The difference is that the principal itself is automatically adjusted based upon the CPI (Consumer Price Index). When inflation goes up, so does the principal. When inflation goes down, so does the principal. The coupon payout thus also goes up (or down) even though the interest rate is fixed. TIPS provide a relatively secure investment income, while stabilizing your principal.
In uncertain times, TIPS, or a TIPS ETF, can be a welcome addition to any investment portfolio. But it’s important to understand the associated tax implications. For a U.S. investor, any upward adjustment of principal is considered a gain, just like the coupon, and is taxed when it occurs, even though that principal increase is not fully received until maturity. In addition, it’s important to consider all possibilities. In today’s economy there are no guarantees, which means there’s no guarantee that inflation will go up.
You must also look at your particular situation, and what you want out of your TIPS. If you don’t plan on retirement for a long time, you’ll want to consider a long-duration TIPS. For example, LTPZ (PIMCO 15+ Year TIPS) is designed to track the return of the BofA Merrill Lynch 15+ Year TIPS Index. The index is unmanaged, and is made up of U.S. Treasury Inflation Protected Securities with a minimum of $1 billion in outstanding face value, and having a remaining term to maturity of at least 15 years.
Regardless of your choice, you will want to evaluate the associated yield. Determine the break-even rates when compared to Treasuries of the same maturity. And, of course, much depends upon whether inflation actually does increase, making TIPS more desirable.