Let’s talk about bonds! You scarcely hear or read much about bonds. The stock market, especially in recent days with the Brexit, grabs the headlines all the time. Bonds just aren’t glamorous, but they’re an important part of your retirement portfolio. They provide safety, stability and steady interest payments—three things that will help sustain your lifestyle during retirement. One thing, though, that most bonds don’t offer is inflation protection. And, as you well know, the cost of living tends to rise almost yearly. But there is one kind of bond that adjusts for inflation: Treasury Inflation-Protected Securities or more commonly referred to as “TIPS.”
You see, our economy is managed with mild inflation as part of its strategy, with 3% being the target rate. Think about what a new car, your weekly grocery bill and cable TV cost 20 years ago. I guarantee you that just about everything costs more today. A $50 bag of groceries, for instance, now costs $77 because of inflation. TIPS are unique because they are guaranteed to keep pace with inflation as defined by the Consumer Price Index (CPI), offering more security during your retirement.
To compensate for issue costs, TIPS have two components: the first is the coupon (guaranteed interest rate of the bond) and the second is the inflation premium. To illustrate, if a $1,000 regular government bond was issued with a 3% interest rate, the bondholder will receive a $30 interest payment. However, if there was a 10% rise in the CPI, that bond would have no inflation protection, but TIPS would compensate for the increased cost of living. Now let’s compare the previous bond with a TIPS bond issued with a lower interest rate of 2% and 10% inflation. The TIPS bond holder is given the interest plus a 10% inflation premium which is added to the face value ($1,000) of the bond. So the bond is now valued at $1,100, and the bondholder is paid 2% of that amount or $22 of interest earnings. In this case, the TIPS bondholder out earns the regular bondholder.
Just like there are no perfect people, there are certainly no perfect investments, and this applies to TIPS as well. Some disadvantages are:
• TIPS are issued at lower interest rates than comparable bonds.
• The inflation boost when added to the face value of the bond is taxable (unless you hold TIPS in a tax-favored account).
• If the Fed raises interest rates, but there is no inflation, TIPS will not go up in value.
If you’re diversified, though, TIPS can be an attractive part of your retirement portfolio. In designing a portfolio, you want to have a mix of assets that can move inversely under different market conditions; bonds and stocks work in concert with one another in your portfolio. If you don’t include enough risk (think stocks), your investments may not earn an adequate return to meet your goal. However, with too much risk (think not holding enough bonds), the money may not be there when you need it.
Having the right mix of stocks and bonds can reduce your portfolio risk, your potential losses, and–with TIPS–offer you inflation protection. Sure, bonds aren’t glamorous, but they can play a significant role in achieving your financial goals and a successful retirement.