With more and more economists predicting higher inflation in the near future, many people are considering what is the best vehicle to protect the value of their dollars. While gold has always been, well the “Gold Standard,” the United States Treasury has come up with a plan to pull in dollars to use for the dramatic increase in government spending and record deficits.
Treasury Inflation Protected Securities, or TIPS, are what the government is trying to use to give investors the closest thing to a sure bet. These bonds have the full backing of the U.S. government and provide investors with returns that will keep pace with future rates of inflation, as measured by the U.S. Consumer Price Index. You can buy them directly from the government, but it’s easier, and may be a better investment decision in many cases, to buy low-fee investment funds that hold TIPS.
Many advisers are recommending TIPS, both for their safety and because of widespread concern about the inflationary implications of record government deficits. With most investors becoming more cautious about their holdings due to record losses in the market in 2008. They are also wary of risky investments as they near or reach retirement age.
Tips for TIPS
TIPS are sold at auction several times a year in maturities of 5, 10 or 20 years. They pay a fixed rate of interest, but that rate is applied to a fluctuating principal amount of a TIPS bond which rises with inflation or falls with deflation. Interest payments are made every six months. Although TIPS are generally touted as protection against inflation, they also offer some protection against deflation. TIPS guarantee to pay at least their original principal at maturity, so if prices double during the life of a TIPS bond, a $1,000 TIPS would automatically increase to a principal value of $2,000. If prices fall by 50 percent, however, that $1,000 bond would still have a principal of $1,000 instead of being worth $500.
Income from TIPS comes in the form of interest payments as well as any annual inflationary increase in the principal value of the bond when the inflation rate is positive. These gains are exempt from state and local taxes but not federal taxes. For most people, this means TIPS should be held in a retirement account that would take advantage of current tax laws to protect as much of the gains as possible.
There are a few choices for investing in TIPS funds. Many people are buying ETFs which stands for Exchange Traded Funds. These funds invest in a variety of TIPS and there are also low-cost TIPS mutual funds. Some examples include the iShares Barclays TIPS Bond Fund, one of the category’s largest ETFs, and Vanguard Inflation-Protected Securities, a large TIPS mutual fund. Together, the two funds hold more than half of all TIPS dollars invested through fund companies.
Using a broker to buy TIPS directly for your retirement account will mean you’ll pay a purchase commission but not an on-going management fee as you would with a TIPS fund. However fund fees are not steep; both the Barclays and Vanguard funds charge just two-tenths of 1 percent. ETFs, which charge commissions whenever you buy or sell holdings, could become costly if you change your TIPS holdings frequently. Mutual funds generally allow cheaper conversions, but you should check out the details before investing in either an ETF or mutual fund TIPS account. Investors in TIPS funds have the option of automatically buying more shares with their earnings, and most do. That’s not possible with direct TIPS ownership. So, it’s easier for fund holders to keep their TIPS earnings fully invested. Direct owners of TIPS would have to reinvest their interest payments in other TIPS to enjoy similar benefits. This places quite a bit of responsibility on the back of the investor to keep abreast of changes in the fund market.
If you invest in a TIPS mutual fund or ETF, you’ll receive interest income either monthly or quarterly, depending on the fund’s practices. If you own the funds outright, you get paid every six months by the U. S. Treasury. The big difference between the direct purchase of TIPS and buying them through a fund is in the handling of any inflation-adjusted increases in the principal of your TIPS holdings. Gains for funds and direct ownership will trigger annual taxable income. But if you own TIPS directly, you’ll be on the hook for paying taxes on any principal appreciation during the year even though the gains are only on paper and you won’t receive the increase in principal until your TIPS mature. Funds are required by law to distribute your principal gain to you, so you will be receiving those actual payments as you go.
This is why it is imperative that you consult with your retirement or financial advisor before making any decision.
TIPS funds hold a variety of issues with different interest rates and maturities. Holders need never worry about seeing their holdings mature, as the funds will be regularly replenishing their portfolios. Direct owners of TIPS will face maturity events, however, and may need to own an assortment of different TIPS so that their income receipts are smoothed over time.
If you’re worried that prices may fall and you want to take advantage of TIPS original principal guarantee, you should consider buying new TIPS directly from the Treasury at an upcoming auction. That’s because the funds that hold TIPS purposefully hold a variety of maturities, including some TIPS that were issued five or even 10 years ago. Those earlier TIPS have already experienced a cumulative inflation driven boost in their principal values, some as high as 25 percent. If deflation does become a problem, investors in an existing basket of outstanding TIPS will lose a lot of principal before hitting their original principal guarantees. In other words, if you are worried about long-term deflation, you should be looking at another investment strategy and should consult a financial adviser.
Disadvantages to TIPS
Treasury inflation protected securities offer less interest on capital compared to bonds and other fixed income securities. They offer poor return when inflation rate stays stagnant and in deflation. Earnings from TIPS are taxed unless they are used in non-taxable and non-deferred accounts. Investors cannot actively control their investments, as they aren’t traded as easily as equities. Finally, interest rates are adjusted according to the Consumer Price Index (CPI); a switch from CPI to Chain-weighted CPI can cause problems.
One philosophical dilemma becomes apparent when considering TIPS. The U.S. Treasury is backing the value of your money along with any increase in inflation. Since the Treasury does not produce anything, the only way they can pay you for this increase in value is by either printing money or issuing more securities. This leads to a vicious cycle where issuing new currency devalues the dollar further, thus increasing the rate of inflation. This increase in inflation means that they have to pay out more money on outstanding TIPS, and so on into infinity.
The Gold Option
As of mid 2009, the price of gold is at near historic record levels. This is due to many factors and I will go over a few here. China owns quite a lot of America debt and they are looking to diversify their investments so they are not dependent on the value of the U. S. dollar. They have been buying up as much gold as they can, and other hard commodities, since the recession began in 2008. Still, the U.S. has one of the largest gold reserves in the world and is the largest shareholder in the International Monetary Fund, IMF, our government can choose when and how much gold can be put up for sale by the IMF.
On September 20, 2009, the International Monetary Fund has approved the sale of a limited amount of its gold to shore up its finances. India, along with China and Russia, have indicated interest in such purchases as a way of reducing their position in dollar-denominated securities.
The purchase of the gold will also help these countries to increase their role in IMF operations as they have often complained the IMF is dominated by the United States, its largest shareholder, and European nations.
The fund’s executive board said it decided to sell “a volume strictly limited to 403.3 metric tons”, 1/8th of its holdings in a way that does not disrupt the sale of gold in commodity markets, which already were expecting and discounted the IMF decision.
Gold is a monetary metal whose price is determined by inflation, by fluctuations in the dollar and U.S. stocks, by currency-related crises, interest rate volatility and international tensions, and by increases or decreases in the prices of other commodities. As the value of the dollar falls, the price of gold increases. As an example, if nothing else changed to affect the price of gold except for the lowering of the value of the U. S. dollar, the price per ounce of gold would rise because it now takes more dollars to buy the same ounce as it did before. Gold reacts to supply and demand changes in the commodities market and can also be influenced by consumer spending.
Gold differs from other precious metals such as platinum, palladium and silver because the demand for these metals arises primarily from their industrial applications. Gold is produced for accumulation; other commodities are produced for consumption. Gold’s value does not arise from its usefulness in industrial or consumable applications. It comes from its use and acceptance as a store of value and backing currency.
Over the recent years gold has been used as a hedge against inflation with some of the most important data occurring this century. As inflation goes up, the price of gold goes up along with it. Since the end of World War II, the five years in which U.S. inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During those five years, the average real return on stocks, as measured by the Dow, was -12.33%; the average real return on gold was 130.4%.
Some feel that gold is overvalued at the present time and are looking for prices to drop in the near term. There are some who also feel that speculators or governments have been driving up the price of gold in a similar way that oil prices rose sharply in 2007 and 2008.
The most effective way to diversify your portfolio and protect the wealth created in the stock and financial markets is to invest in assets that are negatively correlated with those markets. Gold is ideal because it is among the most negatively correlated assets to stocks. However, this does not mean you should hold a 50-50 split between stocks and gold. Many portfolio managers recommend placing around 10% of your money in gold to offset any losses in the markets and to protect against inflation.
This is a very complicated subject with opposing viewpoints. You should conduct as much research as needed to determine what strategy fits your situation the best. It is never a good idea to place all of your eggs in one basket and there is no such thing as a sure bet, diversity is almost always the best bet.
Good Luck.
http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm
