Cognitive Investing

In the previous blog posting, I examined how effective gold was as an inflation hedge.  The answer was not very.  In this essay, I tackle the question of how effective TIPS perform as an inflation hedge.  If any asset should protect you from inflation, surely an asset called Treasury Inflation-Protected Securities should do this, right?  Let’s see.

TIPS are bonds that pay a regular coupon (interest payments), just like a Treasury bond.  But unlike with Treasury bonds, the amount you receive when the bond matures is adjusted for inflation, based on the consumer price index.  In contrast, a conventional Treasury bond upon maturity pays the original value of the bond (usually $1000 per bond), without any adjustments for the loss in purchasing power of the currency.

What really matters to an investor, though, is not the nominal (unadjusted for inflation) value of his investment at the end of a period or the inflation-adjusted amount, but the value after both taxes and inflation are taken into account.  Introducing the element of taxes changes the math of a TIPS investment in ways that few investors fully appreciate.

To illustrate this, I calculated the return for a TIPS investor with a number of different inflation rates to see how much protection is offered.  For purposes of this table, I assumed a 25% federal tax rate.  If this is not your marginal federal tax rate, then you should make adjustments accordingly.  The math is straightforward.  Treasury securities are exempt from state taxes, so the differences in state income tax rates do not affect these calculations.  Holding TIPS in a tax-deferred account does not materially change the situation either, since taxes will still have to be paid at some point on the nominal gains.

I used a coupon rate of 0.75% for the TIPS bond, which is the rate of the most recent, longest-term security offered.  The nominal return is simply the 0.75% coupon plus the inflation rate.  The after-tax return reduces this amount by 25%, which is the assumed tax rate.  I then subtract the inflation rate to arrive at the after-tax and after-inflation return, which is what measures the true return on an investment.  The second row of the table with 2.5% inflation is the closest to the current situation.

As you can see by examining this table, the amount of protection that TIPS provide diminishes as inflation increases.  At current levels of inflation, a TIPS investor actually loses a very small amount of his investment.  If an investor is in a higher tax bracket, the slippage is even more than is listed above.

Technically the securities should be named “Treasury Inflation-Indexed Securities,” but TIIS does not have the same ring to it that the acronym, TIPS, does.  Indexing provides some protection, but not complete protection against the ravages of inflation.  If for some reason we should enter into a hyperinflationary environment, or even one in which the inflation level reached levels similar to that of the late 1970s, a TIPS investor would lose even more purchasing power than the 1.94% decline listed above on the last line with inflation at 10%.  Investors in higher tax brackets should be concerned even more.

So how effective are TIPS as an inflation hedge?  They are certainly better than a conventional Treasury bond, but they fall short of providing total protection due to the tax effects.  Very few TIPS investors are aware of this shortcoming and have made erroneous assumptions about the ability of TIPS to preserve the purchasing power of their investment.  Caveat emptor.