Q I believe that inflation and rising interest rates lie ahead. I have heard of TIPS bonds which are supposed to go up with inflation. What are TIPS, and how do I invest in them?
A Bonds or fixed income-type investments play an important role in a well diversified portfolio. Bonds are simply debt obligations that are issued by government entities, corporations, etc. They pay interest plus they repay principal at some date in the future. Rising inflation is one of the factors that can cause interest rates to go up. Unfortunately, if you are holding these investments, rising interest rates can cause the value of these investments to decline. Think of it as a see-saw. As rates go up the price of bonds go down and vice versa. This is known as market risk (i.e. you may receive more or less than originally invested if sold prior to maturity).
There are several ways to buy bonds. You can own them directly by buying and holding the individual bonds or you can own them indirectly by buying into a bond mutual fund, exchange traded fund (ETF), or a unit investment trust (UIT). Many people prefer to own bonds directly because they know what their interest payments will be and they know that they will get their principal back if held to maturity. These bonds are still subject to credit or default risk (i.e. the issuer may not be able to meet their obligations). Others prefer to own bonds indirectly. Indirect ownership can provide you with diversification and/or professional management that you might not get by owning individual holdings. However, in an indirect ownership scenario, the portfolio has no set maturity as the underlying bonds are constantly being bought and sold. You need to consult the fund's prospectus and other documents to determine the fund structure and maturity/duration targets. It is important to match the fund's "duration" with your needs and goals.
With this little bit of fixed income "education," let me address your question on TIPS. TIPS are Treasury Inflation-Protected Securities. TIPS were designed to protect against inflation risk. They are bonds issued by the U.S. Treasury and they are an obligation of the U.S. government. Unlike traditional bonds that pay a fixed amount of interest, TIPS pay a fixed amount of interest plus the principal is adjusted to reflect the current inflation rate. Interest is then paid on this adjusted amount. TIPS were designed to give you a "real" fixed rate of return in addition to a return to compensate for inflation. TIPS can be owned through the direct and indirect ownership methods that I discussed earlier. TIPS can be a consideration in a well diversified portfolio and they can help to offset the purchasing power loss due to inflation. It is possible for interest rates to increase without a corresponding increase in inflation. Therefore, TIPS can still be subject to market risk in a rising interest rate environment.
Bonds and fixed income investments should be included in a well-diversified portfolio. You should be careful to understand the risks that can go with these investments, primarily market risk, default risk and inflation/interest rate risk. Diversifying across different types of holdings and in different maturities and durations should be considered. As with stocks and other investments, diversification does not guarantee against market loss or insure market gains. It is a technique to help manage investment risk.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Greg Epps is a registered representative and Certified Financial Planner with Epps Financial Partners. Securities are offered through NEXT Financial Group Inc., member FINRA/SIPC. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.