Treasury Inflation-Protected Securities, known as TIPS, are instruments designed to protect investors against the corrosive effects of inflation. What's not to love?
David Darst, of Morgan Stanley Smith Barney, recommends TIPS. He writes in an email: "From a long-term portfolio construction perspective, TIPS offer diversification, protection against rising CPI inflation, usually better-than-cash returns and generally low correlations of returns both with stocks and with straight bonds."
He adds this caveat: TIPS may underperform during periods of rising real interest rates or stable declining inflation rates. But he does not expect the first scenario, because real rates are low versus history. He adds that stable declining rates of inflation may prevail for a while. "Therefore, we have exposure to TIPS, but we are underweight versus our normal strategic weightings." As for the taxation of TIPS for individual investors, we have advised holding them in tax-free or tax-deferred accounts.
Ronald Florance, managing director of investment strategy and chairman of the asset allocation committee at Wells Fargo, says that the relatively young instruments are taxed "so punitively" that the only way they make sense is in a tax-deferred account. He walks us through an example in which an investor could actually be underwater on this super-safe investment.
Say an investor buys a TIP with a par value of $100. Say inflation moves to 3%. The par value of the bond moves to $103. The investor has to pay income tax on the $3 increase, even though she hasn't sold the bond, and hasn't realized the gain yet. Say she had a 10-year TIP, in that time inflation could move to 4%. "That's a big thing, you paying ordinary income tax on 4%," says Florance. "Say it's close to $2, but the yield on the bond is only 1%. The yield on your bond won't even pay the tax liability."
"Admittedly, it's a what-if scenario, but it's not inconceivable. So it is very conceivable in a low interest rate environment and rising tax rate environment that a TIPS could [generate] a negative cash flow because of that tax. We don't like that. The only way to own them is in a 401k or IRA, so you don't have to pay that phantom tax," says Florance.