By Kirk L. Brown
Many investors have fled to safety, buying up mountains of Treasury securities. Massive federal government intervention to prevent an even more calamitous economic and financial crisis has already occurred, and President Obama’s administration promises more will come.
Federal Reserve Board officials have taken several extraordinary measures recently in an attempt to arrest the decline in the economy and unfreeze credit. Among other things, they lowered the overnight Fed Funds rate and committed to purchasing mortgage and other securities in the open market.
Effectively, the Fed is trying to reflate the economy. Inflationary concerns of mid-2008 have been replaced with deflationary concerns, and tight credit conditions have led to a significant retrenchment in spending.
But given the stimulus measures enacted through various fiscal and monetary programs, investors should become concerned that, while the markets are currently experiencing low inflation, higher inflation could be a real concern in the future, possibly the very near future. One security option to help protect investors from the effects of inflation is Treasury Inflation Protected Securities (TIPS).
First issued by the U.S. Treasury in 1997, TIPS are U.S. government guaranteed bonds that protect investors from rising inflation as they guarantee investors a real rate of return above inflation. The coupon payment is calculated as a fixed percentage of principal; however, the principal fluctuates with inflation and deflation based on changes in the Consumer Price Index. TIPS also provide protection from deflation as redemption is at the greater of the inflation adjusted principal or original par amount. The coupon rate represents the real rate of return required by investors at the time of issuance and increase or decrease with inflation or deflation as the fixed coupon rate is applied to a growing or falling principal balance. TIPS cash flows are more back-end loaded because their real coupons are lower, but their principal grows with inflation.
But there are issues that need to be addressed concerning how interest rate movements affect TIPS prices and their potential to offset inflation. Investors need to remember that TIPS are a bond and behave like any other bond. If interest rates rise, the value of a TIPS issue will fall, just like a nominal bond. Therefore, higher interest rates could negate any inflation adjustment.
TIPS mainly work best within a mutual fund structure instead of as an individual security. If an investor buys a TIPS issue individually, they must pay an annual tax on any increase in principal value due to higher inflation, even though the TIPS issuance has not matured and they have not received their principal inflation adjustment. However, while a TIPS mutual fund investor would not have to pay a tax on principal inflation adjustments on TIPS held in a mutual fund, they would incur fund fees which an individual purchasing a TIPS issue would not incur.
While both TIPS and nominal Treasuries are sensitive to changes in real interest rates, their exposures differ with respect to changes in expected inflation, the inflation risk premium and realized inflation. The important issue driving TIPS performance versus nominal Treasuries is the performance of realized inflation relative to expected inflation, as any inflation risk premium is typically small. Overall, with inflation concerns looming, the TIPS market continues to grow at a good pace and is becoming an integral part of the 2009 Treasury schedule as auctions are planned in the five-, 10- and 20-year maturities.
The key question, of course, is whether or not, and how quickly, the monetary and fiscal stimulus already enacted and still to come will arrest the economic decline and lay the groundwork for recovery. No one knows that answer, and similarly, no one knows what the long-term effects of such stimuli will be on the economy and the markets. But in the current environment with so much liquidity on the sidelines, higher inflation is quickly becoming a strong possibility.
Kirk L. Brown, CFA, is managing director, Trust and Alternative Investments, of American Beacon Advisors and manager of the American Beacon Funds.