Do I Need TIPS?

SNW Asset Management is often asked about TIPS and whether it is an appropriate time for investors to purchase them. TIPS offer some unique benefits to investors, but you have to be very careful about how they are used. First and foremost, we recommend investors only own them in accounts that are tax-advantaged. The inflation adjustment of the principal amount on TIPS can lead to a tax liability in the current year even though the inflation benefit is only realized when the bond is sold or matures. Any tax accountant will tell you it can be a nightmare to account for them properly from a tax standpoint.

While TIPS do look attractive from an inflation TIPS of view, we are still concerned about them from a value perspective. When inflation rises, often times that coincides with the economy doing better. As the economy grows, companies are able to charge more for their products or services, demand for commodities rises causing prices to adjust upwards, and workers are able to demand more income from employers as demand for certain skills increases. Economic growth can lead to the real level of interest rates rising as well, which can ultimately hurt the value of TIPS. So, TIPS can perform well in a rising inflation environment, but they are not completely immune from the effects of rising interest rates.
One final concern with TIPS is availability. The structure of TIPS calls for the maturity value to be the higher of par or the inflation adjusted principal amount. While the risks of future inflation are currently growing, we are currently in a deflationary environment, which could cause the principal value of outstanding TIPS to be adjusted downwards. It is in the client’s best interest to purchase TIPS as close to par as possible to avoid the risk of future deflation reducing the principal investment value. Currently the Treasury is only issuing five, ten year and 20-year TIPS quarterly. This can make it difficult to structure a portfolio of TIPS for clients with shorter maturity constraints.

SNW Asset Management is not currently holding TIPS in our client portfolios. Instead, we have made the decision to hold corporate bonds were appropriate. Corporate bonds perform well in inflationary environments as the credit quality of corporations credit tends to improve under these circumstances. Typically companies are able to raise prices on the goods they produce to offset inflationary forces, while their financial obligations tend to rise much slower. Also, at present corporate bonds offer much higher yields than TIPS which helps to offset the effects of future inflation. Corporate bonds do introduce credit risk to the portfolio, so they are not suitable for everyone.

In conclusion, TIPS are not a strategy that we would recommend in the current deflationary environment and global economic conditions ensure that inflation, while on the horizon, is not imminent.