Although not an immediate concern for many investors, rising inflation is a possibility that you should never ignore. Of course, real estate, precious metals, and other tangible assets are often viewed as hedges against inflation, yet they do carry certain risks. There is another alternative that you may want to consider that can provide a return above the rate of inflation and has the government’s backing.
Treasury issued Treasury Inflation Protected Securities (TIPS) offer guaranteed principal (b acked by the US Government) that increases with the consumer price index (CPI). In addition, they provide a fixed current yield. TIPS are a fairly stable asset whose values have little or no relationship to stocks and other bonds. For example, when inflation and interest rates rise, bonds usually go down. But TIPS generally drop little or not at all ( Bloomberg Wealth Manager, July/Aug. 2002, pg. 85). On the other hand, when interest rates trend down and bonds increase in value, TIPS usually stay flat or may go up less than bonds. And when stocks are falling, TIPS often rise (Bloomberg Wealth Manager, July/Aug. 2002, pg. 85).
Your investment in TIPS would grow with the CPI, and the interest rate would apply to the inflation-adjusted principal. This means that as your principal increases with inflation, the interest payable will also increase. The principal is adjusted every six months by the CPI and interest is paid on the adjusted principal.
Note that if inflation decreases and the CPI falls, your interest payments are based on this smaller amount and will decrease. At maturity, you receive the higher of the inflation adjusted principal amount or par value.
For example, if inflation is 1% and the coupon rate is 3% on a $10,000 investment, after six months your principal would be adjusted to $10,100 and you would receive a $151.50 interest payment. And by the end of the year if inflation had risen to 3%, your principal would be adjusted to $10,300 and you would get a $154.50 interest payment (Registered Rep, July 2002, pg. 50).
For a brochure about TIPS and how they may be able to provide you with an opportunity to earn a rate of return above the inflation rate, return the enclosed coupon.