It has been suggested that TIPS-Treasury Inflation-Protected Securities-are a better choice for dividend growth investors than dividend stocks themselves. The reasoning is that in periods of high interest rates, the income from TIPS will keep up with inflation, while the annual growth in dividends of dividend growth stocks will not. The income advantage of dividend growth stocks over the past few years is dismissed as "recency bias."
The suggestion about TIPS is intriguing. It implies that your money-both principal and cashflow-can be protected from inflation with TIPS in a way that cannot be achieved with dividend growth stocks.
Let's look under the hood. In the following discussion, everything that is indented (as a quote) comes from Treasury Direct, a U.S. government web site that is chock full of information.
What are TIPS?
Here is a quick summary of what TIPS are, pieced together from various places on Treasury Direct.
The U.S. Treasury has been issuing…TIPS since 1997. TIPS provide investors with an investment option that protects against the effects of inflation. Like all marketable US Treasury securities, TIPS are backed by the full faith and credit of the US Government. TIPS are available to individual and institutional investors alike.
Earnings from TIPS are exempt from state and local income taxes just as other US Treasury notes and bonds. TIPS owners pay federal income tax on interest payments in the year they are received and on growth in principal in the year that it occurs. Treasury offers TIPS in terms of 5, 10, and 30 years.
You can buy TIPS in $100 increments…. You can buy them directly from the Treasury or through a financial institution or broker.
TIPS are marketable securities whose principal is adjusted by changes in the Consumer Price Index (CPI). TIPS pay interest every six months.
Note that "…principal is adjusted by changes in the Consumer Price Index." That protects your principal against inflation and makes TPS significantly different from conventional bonds, whose principal is fixed and subject to the damages inflicted by inflation. As we will see, the principal adjustments also lead to interest adjustments, which are TIPS' analog to rising dividends.
You can buy and sell TIPS in the secondary market before maturity. Of course, the value of a security sold in the secondary market before maturity is subject to market valuation. This may result in either a capital gain or loss, depending on the prevailing market price at the time of the sale.
For simplicity, throughout the rest of this article, I am going to treat TIPS as if one buys one at issuance and holds it to maturity. I do this because the suggestion about TIPS had to do with its income characteristics. Buying and selling TIPS for profit on the secondary market would be a trading strategy outside the scope of this discussion.
How does inflation protection work with TIPS?
TIPS adjust both their principal and cash flow for inflation.
…TIPS provide protection against inflation. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.
The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
The TIPS' principal adjusts each year in accordance with inflation. The cash flow-the interest-is also adjusted, because the fixed interest (or coupon) rate is applied every six months to the adjusted principal. The application of a fixed rate to a rising principal base causes the cashflow from TIPS to rise in step with inflation too.
Again, we see analogs to dividend growth stocks: In the long term, such stocks' principal rises along with company earnings, and so do their dividends. TIPS have a clear advantage in steadiness, because neither their principal value nor their income is put through a market grinder. Even though dividend growth stocks tend to be low-beta performers, they are subject to market risks and crashes as well as to individual stock risks. TIPS simply move with the CPI, and since there is no market intermediary, the movement is relatively gentle every year.
What is TIPS interest?
TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.
As you can see, the cashflow payments made on TIPS are called "interest," just as with a conventional bond. The interest rate on the TIPS is fixed at issuance. But the interest (rate times principal) does change, because the fixed rate is applied to a rising principal base.
The U.S. Treasury uses an auction process to sell [TIPS] and determine their rate or yield….. Treasury auctions occur regularly….The auctions are announced in advance in most major newspapers and through press releases…. All auctions are open to the public.
The auction process itself is fairly complex and need not be detailed here. Suffice it to say that the interest rate on each TIPS is determined through the auction process, and the rate then remains fixed for the life of the TIPS.
How much is TIPS' interest?
Here is a table showing the results of the most recent TIPS auctions:
30 Year TIPS
10 Year TIPS
4.4 Year TIPS
9.8 Year TIPS
29.4 Year TIPS
9.10 Year TIPS
(Source: "Recent Note, Bond, and TIPS Auction Results," Treasury Direct, accessed 2/18/2012, direct link. An entry like "4.4 Year TIPS" means a "reopened security" with a remaining term of 4 years and 4 months. Per Treasury Direct, "In a security reopening, the U.S. Treasury issues additional amounts of a previously issued security. The reopened security has the same maturity date and coupon interest rate as the original security, but with a different issue date and usually a different purchase price.")
You'll immediately notice a huge difference in the yields between TIPS and dividend growth stocks. A typical dividend growth stock portfolio can easily be constructed of name-brand stocks like Johnson & Johnson (NYSE:JNJ), Intel (NASDAQ:INTC), and AT&T (NYSE:T) that has an initial portfolio-wide yield of 3%-4%. That is not currently possible with TIPS.
In the past, according to data I found on the Treasury Direct site, TIPS' interest rates ranged as high as 3 7/8 %. Some day, when interest rates rise again, higher initial yields will undoubtedly be available. They are not now.
As stated earlier, each TIPS' fixed interest rate is applied to the underlying principal, which is adjusted over time per the CPI. That is how the interest payout (in dollars) rises to protect you against inflation. If you divide the current interest payment by the original cost of the TIPS, you would arrive at an analog of yield on cost computed on the cost originally paid. The concept is similar to the dividend growth stock world: The initial yield at which you purchase a stock never changes, but its yield on cost rises as increased dividends are declared.
How are TIPS' principal and interest payments adjusted?
TIPS pay interest every six months. The interest rate is a fixed rate determined at auction. Though the rate is fixed, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate.
In practical effect, this means that nearly all annual total interest payments are higher than the preceding years' throughout the life of the security. This is similar to dividend growth stocks, which on an annual basis increase their dividends.
TIPS principal is adjusted according to changes in the CPI. Treasury calls this process "indexing." It determines the index ratio by dividing the current CPI by the CPI that existed when the securities were issued, which is known as the "reference CPI."
Therefore, as measured by the index ratio, the principal changes at the same rate as the CPI. Since interest payments are a fixed percentage of the current principal value, each interest payment changes as the principal adjusts in step with the CPI.
The reference CPI is based on the CPI-U [the non-seasonally adjusted CPI for all urban consumers] for the third preceding calendar month.
Thus, the indexed CPIs are known a couple of months in advance. Treasury Direct provides lookup tables that show the principal adjustments on the underlying TIPS. Because of the time lag, at the time of this writing, tables exist through the end of March, 2012.
I randomly picked out one TIPS as an example. On July 15, 2002, a 10-year TIPS was issued at fixed 3% interest. It will mature on July 15, 2012. The "reference CPI" on the issuance date in 2002 was 179.8000. The table for March, 2012 shows that on the last day of March, 2012, the indexed CPI will be 226.63297, or 1.26047 times what it was on the date the TIPS was issued.
In other words, the principal amount of the TIPS will be about 26% higher than it was on its date of issuance. That's how a TIPS protects your principal: The value of the TIPS adjusts right along with the CPI. Of course, you cannot get your hands on that money unless you sell it. But this feature provides a significant advantage over conventional bonds. Corporate bonds and most other Treasury issues simply return your nominal purchase price to you at the end of the bond's term. The purchasing power of that money has been eroded by inflation throughout the life of the bond. But with TIPS, the money returned to you is not the nominal amount you paid, but that amount adjusted for inflation. Thus your money has been protected from inflation.
The situation is similar regarding the cash flow from the TIPS. The next interest payment on the TIPS in the example will be about 26% higher than the initial yield, or 3.78% compared to the 3% interest rate fixed at issuance. That is the yield on cost that the TIPS has achieved in nearly 10 years of existence after starting with an initial rate of 3%.
Can the principal value of TIPS decline?
The answer depends on the timeframe.
Over a short time period, while you hold the security, both its value and interest payments can decline if there is deflation.
[If there is deflation,] the principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same.
However, if you hold a TIPS to maturity, you are protected by law from receiving back any less money (in nominal dollars) than you paid.
You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.
It is unlikely that inflation would be negative for the entire life of a TIPS. So in the most likely course of events, the value of a TIPS will not decline. This is significantly different from the principal value of dividend growth stocks, whose price is a function of the stock market and can go either up or down over both short and long time periods.
What are tax considerations with TIPS?
Earnings from TIPS are exempt from state and local income taxes, as are other U.S. Treasury securities. TIPS owners pay federal income tax on interest payments the same year they receive those payments, and on growth in principal in the year it occurs. Investors holding TIPS will have two tax statements each year: an IRS Form 1099-INT showing the interest paid on the security and a 1099-OID2 showing the increase or decrease in the security's principal value….It's possible to get a 1099-OID with a negative amount. In this case, it means deflation occurred after you bought the TIPS, which reduced the security's principal below par value - what you paid for it - or below what it was during the last tax year. [q]
If the principal of your TIPS grows in a given year, that growth will be taxed as income in that year, even if your security hasn't matured and, therefore, you haven't received payment of the principal.
Note the contrasts with dividend growth stocks:
- TIPS interest payments are exempt from state and local taxes, but at the federal level, they are taxable at ordinary rates. Dividends under current law are taxable at favorable federal rates, and they are also subject to state and local taxes.
- TIPS' inflation adjustments to principal are taxable as income in the year they are made, even though the owner will not realize those gains until maturity. Taxes on principal growth in stocks are not due until the stocks are sold.
My own conclusions
As I have mentioned in a couple of comments recently, I am coming to the view that preservation or safety of principal is a very personal consideration for each investor. TIPS offer total safety of principal. Even in the unlikely event of deflation over the life of a TIPS, your principal will be returned at the end of the TIPS' term. If safety of principal is highly important to you, TIPS become relatively more attractive.
TIPS' growth rate-both principal value and interest payments-matches inflation. It is therefore constrained by inflation. If "keeping up with inflation" is your benchmark, then TIPS provide exactly that-no more and no less, ignoring taxes.
At the current time, TIPS cannot touch dividend growth stocks in initial yield. It would take a sizable increase in interest rates for TIPS to become competitive with dividend growth stocks in yield. Since my focus in dividend growth investing is on the income stream, this is pretty much a knockout factor for me. It is realistic for me to put together a dividend growth portfolio with an initial yield of around 4% and a likely annual dividend growth rate that places a goal such as 10 by 10-10% yield on cost within 10 years-in reach. You simply can't do that with TIPS. As we saw in the example above, even a TIPS that began with a decent interest rate of 3% 10 years ago has a yield on cost now of less than 4%. While that cash flow has been protected from inflation, it has also been constrained by inflation.
Dividend growth stocks generally increase their income faster than inflation. (See my article, "Do Dividend Increases Keep Up with Inflation?") In most cases, TIPS cannot keep up with the pace of income increases available from dividend growth stocks. Again, if there is a sizable increase in the rate of inflation, like back to the mega-inflation of the 1970's, the relative advantage in income growth rates would begin to swing in favor of TIPS as compared to dividend growth stocks.
That said, for me TIPS are not at this time a competitive alternative for my money compared to dividend growth stocks. Since my focus is on income far more than preservation of principal, the safety in principal offered by TIPS does not overcome the huge advantage that dividend growth stocks offer both in initial yield as well as annual income growth rates. I am comfortable enough with the inevitable price swings of the stocks in my dividend growth portfolios to live with those oscillations as a trade-off for the much higher income and income growth rates that the stocks offer compared to TIPS.