Is there a bond that grows with CURRENTLY RED-HOT inflation? An introduction to TIPS

I previously wrote about the 100-year Portfolio (interesting article by the way) and TIPS appeared in the Fixed-Income category. It wasn't even the first thing people would think of when it comes to bonds, aside from the SSB and bond Funds. Bonds are just like you lending the money to the government/entity. They have to pay you interest for lending money to them. There are thousands of different bonds out there but today I want to share a special type of bond which are called TIPS

What are TIPS exactly?

TIPS is the abbreviated form for Treasury Inflation-Protected Securities. These are bonds issued by the US Treasury and is a form of Inflation‑Linked Bond (ILB).

What do you mean, is it tied to inflation??

Exactly right! In order to show you how exactly TIPS work, let me illustrate a few scenarios.

BUT FIRST, here is how most people benefit from TIPS. Every TIPS will have a coupon (1% for example) that is paid out every year which is like an interest on principal loan.

Scenario 1: Inflation is happening and you are holding TIPS.

Now imagine the CPI (Comsumer Price Index) has increased by 2% this year when you bought TIPS last year. This means your principal loan amount will increase as well, so you might have loaned $1000 to the government BUTTTT due to the inflation-linked characteristics, you have loaned $1020 to the government. So your interest would be:

$1020 x 1% interest = $10.2

instead of

$1000 (your original loan) x 1% interest = $10

Even though you did not put the $20 extra in.

Scenario 2: Deflation frenzy instead

It would not be the ideal scenario but it is possible especially when you are holding TIPS for a long time. But TIPS protects your original loan amount from non-stop deflation. So rest assured that your interest will always be at least:

$1000 (your original loan) x 1% interest = $10

Don't believe it? Check out the Dividend distribution of a TIPS ETF (SCHP)

At current market prices (US$56) I am receiving 1% dividends THIS MONTH!!! This is due to elevated CPI-data.

Pros & cons of TIPS

Ideally, this is the environment the financial world has to be in in order to benefit the most from TIPS

• High inflation rate

That's it. If inflation rate is low or even goes to deflation, TIPS holders will lose out to conventional bonds as the interest rates is typically lower for TIPS compared to bonds.

But this is the ideal time to take advantage of TIPS as governments around the world have flagged inflation to be coming anytime soon.

How do you buy TIPS?

There are currently 2 ways possible to own some TIPS in SIngapore

• Buy direct from treasurydirect.gov
• Buy TIPS related ETF (SCHP)

Buying from treasurydirect is not a straight forward proccess compared to buy a TIPS ETF hence I am doing this.

One of the good ones is called the Schwab U.S. TIPS ETF, which pays out coupons via dividends every month.

Conclusion

TIPS provide a great opportunity of fixed income investors amidst the increasing interest rate environment, which can outperform high-yield savings account but still less risky compared to equities.