En español | Worried about inflation? The January 2017 Consumer Price Index showed a 0.3 percent increase in December (about 3.6 percent annualized) and a 2.1 percent increase over the past 12 months. Possible new tariffs on foreign goods and pressure on wages may push inflation even higher. Though history shows that stocks provide long-run inflation protection, it comes at great risk — especially when the market is near an all-time high. So what's the answer? Consider inflation-protected bonds for part of your investment portfolio.
Tips on TIPS
Most bonds pay a fixed amount of interest. Thus, rising inflation eats away at the principal while the annual interest payment stays constant and buys less and less each year. That's why prices on existing bonds generally decline when inflation drives up interest rates. But Treasury Inflation-Protected Securities (TIPS) are a different animal because part of their interest payments are linked to the government's Consumer Price Index for All Urban Consumers (CPI-U). If inflation goes up, you make more.
Owning individual TIPS creates some complexities because some of your return comes in cash payments while the rest comes from price appreciation. Those complexities can also create tax issues, such as owing taxes on income received as price appreciation when you didn't receive the cash. (This Investopedia piece on TIPS explains some of the complexities of owning TIPS directly.)
I Bonds — an alternative to TIPS
If you don't like seeing the value of your TIPS going up and down, another similar alternative is to purchase I Bonds. These are I Savings Bonds issued by the U.S. Treasury that are also linked to inflation. They have an advantage over TIPS or TIPS funds in that you generally won't have to pay taxes on the income until you cash in the bonds. A disadvantage is that you can't sell for at least a year and must pay a small penalty if you sell within five years. You are also limited to a buying maximum of $10,000 a year per person from TreasuryDirect, though you can buy an extra $5,000 by opting to receive your income tax refund in I Bonds. TreasuryDirect is the government service that sells Treasury securities directly to consumers, bypassing brokers.
I typically recommend owning TIPS through funds like the Vanguard Inflation-Protected Securities Fund (VIPSX) or the iShares TIPS Bond ETF (TIP). Both are currently yielding just slightly more than inflation. These funds distribute the price appreciation of the underlyingTIPS securities as well as the interest payments.
Because they are U.S. Treasury securities, you won't owe any state income tax on the income whether you buy them directly or through a fund. But if you sell either, it's possible you would owe capital gains taxes.
I regard TIPS as the least risky investment on the planet if you hold them over the long run. That's because real inflation-adjusted returns are more important than nominal (noninflation-adjusted) returns. After all, it's a bad thing if you earn 5 percent and inflation is 6 percent because your spending power declines. Yet TIPS are more volatile than fixed-rate bonds as popularity varies based on recent inflation perceptions, which are historically inaccurate. This means that you must own them for the long run and not react to short-term price movements.
Though higher inflation (with likely higher interest rates) is a possibility, it's not a certainty. Economists have a terrible track record of forecasting rates. That's why I own traditional fixed bonds and bank certificates of deposit along with TIPS funds and I Bonds. Because both TIPS and I Bonds provide some inflation protection, you should consider them for part of your long-term portfolio.