Many advisors tout the benefits of Treasury Inflation-Protected Securities because they think TIPS are the best vehicle for protecting portfolios from inflation. While TIPS were created with good intentions, these Treasury bonds fail to fulfill the purpose for which they were established.

During periods of inflation, generating consistent returns is often a challenge for investors as purchasing power decreases. In essence, the money lent through bonds during inflationary periods provides significantly lower purchasing power once it is paid back.

To mitigate the effects of inflation on bondholders, the Treasury Department in 1997 began selling TIPS, which come with a permanently fixed coupon rate and principal that is adjusted to coincide with changes in the Consumer Price Index. The bonds are issued with five-, 10- or 30-year maturities, and interest is paid semiannually.

On the surface, TIPS would appear to protect investors, but there are inherent problems. For starters, if the securities are held in a taxable account, investors pay an ordinary tax rate on income they will not receive until maturity.

Another flaw is that TIPS present credit risk that is changing to the downside. With Operation Twist, the Federal Reserve accounts for 90% of demand in the longer-dated Treasury market, which includes TIPS. With the Fed competing with school districts, pension plans and other risk-averse investors - the natural consumers of Treasury products - prices have increased and yields have decreased.

Along with an increase in prices, TIPS investors will also absorb adverse effects from the inevitable erosion of U.S. creditworthiness. As the U.S. approaches the point where its debt equals its gross domestic product, Treasuries will lose their risk-free aura and investors will demand increased compensation (in the form of interest) for holding those bonds.

 

A BETTER CHOICE

Since TIPS and other Treasuries have performed well from the standpoint of total return over the past 10 years, many advisors assume TIPS are among the safest investments for clients. Yet investors receive greater inflation protection from other bonds, like Corporate Inflation-Protected Securities. These bonds have a coupon that adjusts for the gross changes in the CPI. The result for the investors is immediate cash flow from changes in inflation with the funds to pay any taxes generated.

TIPS were a good idea, but that idea has been poorly executed. The potential negative implications outnumber the positives and leave investors exposed to risks TIPS were designed to avoid.

 

 

Scott Colyer is chief executive and chief investment officer of Advisors Asset Management.