On sale this week: Inflation-protected Treasury securities.
It wasn’t that long ago that the real interest rate on these bonds was negative. People lent money to the federal government and were assured that they would get back, with interest, less than they started with.
Now the TIPS yield expected in 2056 is 2.7%, almost as high as it has ever been. This bond will outperform the unprotected 2056 standard-issue Treasury, recently paying 5%, if inflation averages at least 2.3% over the next 30 years.
Do you think inflation will average above 2.3%? It’s a reasonable assumption. The latest Consumer Price Index came in with an annual increase of 3.8%.
There is a decent chance that stocks will do better than an actual return of 2.7% over the next 30 years. But they are fickle. An all-stock portfolio would mean sleepless nights for a saver no longer in the workforce.
Put it all together and you have a good case for having a collection of TIPS as the solid anchor in a balanced retirement portfolio.
Inflation hurts bonds that are repaid in nominal dollars, a category that includes most bonds and almost all corporate and mortgage debt. TIPS are immune to this risk, but they share two other risks with conventional bonds.
The big one is interest rate risk, explains Collin Martin, fixed income forecaster at the Schwab Center for Financial Research. Buy a TIPS due some future year and you can be sure of a certain purchasing power return between now and then. But there will be bumps along the way, which will matter if you need to cash out early. When real prices rise, TIPS prices fall. In the market crash of 2022, TIPS suffered along with conventional bonds. When real prices fall, TIPS prices rise.
A more theoretical risk is bankruptcy. Martin notes that the three major rating agencies—first Standard & Poor’s, in 2011, and since then Fitch and Moody’s—have downgraded the federal government from AAA to AA+ in credit quality. Chronic fiscal deficits are hard to ignore. Apparently bonds from Microsoft, a rare AAA corporate borrower, are safer than bonds.
It’s quite possible, Martin says, that a congressional showdown over the federal debt limit could lead to a suspension of Treasury payments, but it’s likely that the debt holders will eventually be wiped out. It is unlikely, but not impossible, that the US will engage in a restructuring of the kind seen in accidents like Argentina. Says Martin: “We don’t think you’re going to be rigid.”
The US Treasury holds a TIPS auction about once a month, offering bonds maturing in 5, 10 or 30 years. If you’re patient, you could build a multi-maturity TIPS portfolio by participating in multiple auctions. Some brokers, including Schwab, will handle the auction documents for you at no cost.
For faster growth, buy TIPS used. Your broker will offer about 50 issues, with maturities available in most years between 2027 and 2056. You can build a portfolio of TIPS issues without much mental stress.
In early June, yields on TIPS ranged from 0.9% for next year’s crop to about 2.7% for those maturing in 2048 or later. It often makes sense to spread out TIPS maturities over a long period of time. But in the used market it is also important to keep transaction costs low. This means only taking a trade if you can afford to take on at least $100,000 face value, which in traders’ parlance is called 100 bonds.
What to do with smaller stakes: Use a cashier. TIPS funds can be found with expense ratios as low as 3 basis points or 0.03%. (For best buys, see Forbes TIPS Buying guide.) That means you give $30 a year to middlemen for every $100,000 invested. Not bad, but not as good of a deal as you get when you have the patience and means to acquire individual bonds. Buying bonds in the secondary market, at least 100 at a time, and holding them to maturity will result in brokerage costs of more than $6 per year per $100,000 invested.
Here are the steps you would take at Schwab to buy an individual inflation-resistant bond. (Fidelity Investments may offer something similar; it declined to be interviewed.) On Schwab’s home page, select “Research.” Then select “Bonds, CDs, and Fixed Income.” Then, just to the right of the Overview tab, select Find Bonds & Fixed Income.
On the resulting screen, click on the “Both Buy and Sell” box. Enter 100 as the number of bonds you want. Change the bond type from “Corporate Companies” to “Available Bonds”. Towards the bottom of the page, click the ‘Include TIPS only’ box and then ‘View search results’.
Now export your search results to a spreadsheet. Rearrange the sheet so that each line has a coupon and expiration followed by a bid yield and an ask yield. You will earn the ask yield, the lower of the two, since you buy at the ask price.
Add a column to your spreadsheet that calculates the difference between the two returns. You want this difference to be small. The most traded bonds have the narrowest spreads and are the ones you should prefer when putting together a portfolio.
Schwab does not charge a commission for TIPS trades made online. the company and the traders it works with make all their money from the spread between the bid and ask prices. Good news: These days the spreads are pretty tight. In terms of yields, spreads at Schwab have recently averaged 1.2 basis points for bonds maturing in 2031 and later.
All of this seems harder than it is. Your work is limited to choosing a quantity, choosing a bond and pressing the “Buy” button.
A companion article, the Forbes TIPS Buying guidegets into the details: how to choose individual bonds, which mutual funds are the best to buy, how taxes work, and why I Bonds aren’t so great.
