How TIPS Provide a Guaranteed Real Return

Do TIPS really keep up with real inflation? The most important thing to remember is that TIPS provide a guaranteed real return. While this might be a bit complex, here are two ways TIPS can provide you with a guaranteed real return, which I will outline below. In addition, I have included relevant information about real returns versus nominal returns, and individual inflation rate versus the CPI as it pertains to TIPS.

2 Ways TIPS Provide a Guaranteed Return

The Return Cannot Be Less Than the Real Yield to Maturity

First, the return cannot be less than the real yield to maturity (YTM) at the time of purchase. Remember though that there is a difference between the coupon and the yield to maturity. If you buy a TIPS with a 2% coupon and pay above par the YTM will be less than the coupon (if you pay below par, the YTM will be more than the coupon).

You also need to understand that the inflation factor is not paid in the form of interest. Instead, it is added to the principal, this adjustment is called the inflation factor. If you have a positive CPI, the inflation factor rises (and falls with a negative CPI). Thus, it is possible that you can buy a TIPS with an inflation factor of say 110 and have that inflation factor fall, reducing your NOMINAL (but not real) return.

TIPS Cannot Mature at Less Than Par

Second, TIPS have a unique feature that is very valuable: they cannot mature at less than par (100). That means that if you purchased a TIPS with an inflation factor of 110 and from that point until maturity the inflation factor was a negative 20%, the TIPS would not mature at 90, but 100. Thus the real cumulative return would be greater than the YTM at the time of purchase, with the difference being that 10% cumulative deflation in excess of the inflation factor.

Real Returns versus Nominal Returns

It is very important that investors understand that the only returns that really matter are REAL returns, as you cannot spend nominal dollars. Unfortunately, many people are fooled by what I call the “money illusion.” Consider the following simple example. Which return would you rather earn:

• a 10% nominal return when inflation is 12%, or
• a 0% return when there is deflation of 5%?

The 10% nominal return is actually a negative return of 2% in terms of spending power, while the 0% return is actually a 5% positive return in terms of spending power. Making it even worse is that you pay taxes on the “phantom” (nominal) income. So in the example of the 10% nominal return and you are in a 30% tax bracket you only earned 7%, or a real return of negative 5%. The lesson is to focus on the REAL return you earn and ignore the nominal return.

Individual Inflation Rate versus the CPI

Another thing to consider is your inflation rate versus the CPI. Some people’s individual inflation rate will be above average and some below. It cannot be that everyone’s inflation rate is above average. For example, if it is housing prices rising rapidly that is driving the CPI up, then those that own homes already will have a lower than average inflation rate. If it is food prices, then those that spend a high percentage of their income on food will have a higher than average inflation rate. It just depends.

Unfortunately, there really is no good way to hedge your unique inflation rate. Your choices still come down to nominal bonds or real bonds, or taking the risk of owning equities. And equities are not a good inflation hedge despite the conventional wisdom. Stocks are far too volatile to hedge inflation. For example, in 2007 stocks fell dramatically but inflation rose. In fact there is a negative correlation between stock returns and inflation, and the longer the horizon, the more negative it becomes (at least out to five years). Stocks have expected returns that are higher than inflation because they are risky assets. But don’t mix the two issues up, a common error. And also note that investments in commodities (e.g., futures contracts) are also too volatile to hedge inflation.

Besides TIPS, there is one other way to hedge the risk of unexpected inflation and that is to have a fixed rate long-term mortgage. If we experienced unexpected inflation interest rates would rise but your mortgage payment would remain fixed. The result is that in real terms the payments would be falling.

If you are interested in learning more about TIPS I recommend you read either my new book The Only Guide to Alternative Investments You’ll Ever Need (which has a chapter on TIPS) or The Only Guide to a Winning Bond Strategy You’ll Ever Need, which also covers TIPS.

Disclaimer: Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.

Reviewed and Updated October 18, 2011

Larry Swedroe

Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You’ll Ever Need (2008).

Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!