Our TIPS for Inflation Protection

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Headline inflation has been pretty mild, but that doesn't mean investors should ignore inflation protection when putting together their portfolios. Joining me to share some thoughts on this topic is Alex Bryan. He's Morningstar's director of passive strategies research for North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Let's talk about how investors should approach this, starting with life stage. To what extent should whether I'm in drawdown mode--where I'm retired, and I'm pulling from my portfolio--influence how much I care about inflation versus whether I'm still working and earning a paycheck.

Bryan: I think if you're currently in the workforce and drawing most of your income from your salary, there's a good chance that you're going to experience cost of living adjustments, where your salary will grow with inflation over time.

If you're retired and drawing more of your income from the bond portion of your portfolio, in that case it's more important to start thinking about maybe considering an allocation to inflation-protected bonds. I think it really just depends on whether or not you are currently in the workforce or in retirement. As you draw more of your income from your portfolio, inflation protection becomes more important.

Benz: How about my personal inflation area experience? It seems like that should influence it, too. Like, what I'm spending money on and the extent to which those categories are inflating or maybe not experiencing so much inflation. Let's talk about that.

Bryan: Absolutely. So, inflation-protected bonds typically index to the Consumer Price Index, which is a broad measure of consumer inflation and consumer prices. That's based on survey data across thousands of households, and it basically takes the typical experience of a large sample of households to try to gauge what inflation is.

Now, if your expenditures are different than the typical U.S. household--let's say, for example, you spend a lot on medical bills and healthcare--in that case, your inflation experience may be very different from the typical American household.

I think, if that's the case, then inflation-protected bonds may not be as good of a hedge for inflation as you might expect. So, it's really important to kind of gauge your expenses and see if they're similar to the broader U.S. households.

Benz: You've referenced Treasury Inflation-Protected Securities, or inflation-protected bonds. Let's just talk in very general terms about how these bonds work and how they look to incorporate inflation expectations into the return that investors earn.

Bryan: Principal value of TIPS is tied to changes in the Consumer Price Index. So, when inflation picks up, that will increase the principal value of these bonds. In turn, the coupon rate that these bonds pay is tied to the principal value, so as the principal value increases in response to inflation, that will increase the coupon payments that these bonds make.

For example, if a TIPS bond is issued at $1,000, and we have 2% inflation? The principal value will be adjusted upward to $1,020, and then the coupon payment is going to be based on that higher principal value, so you get growth in income with growth of inflation over time.

Benz: How about I Bonds? I know that that's another investment type that some individual investors like to have in their tool kits. They function in a similar way, right?

Bryan: Yes and no. So, I Bonds are very similar to EE savings bonds. These are basically bonds that you can invest a few thousand dollars in them. They provide a fixed rate of interest. On top of that, they provide an inflation earnings rate, so it's tied to the changes in the CPI. So, the ultimate value that you receive from the bond when you go to cash it is going to be tied to changes in the Consumer Price Index.

But, unlike TIPS, these don't pay out regular coupons. So, you don't actually earn income while you hold those bonds. You have to wait until you cash the bonds to actually get the value from those inflation adjustments. So, it can be a good long-term savings vehicle if you are concerned about inflation, but it's not going to give you regular coupon payments the way that a TIPS bond might.

Benz: I guess another thing to know is that you're quite limited in terms of how much of those I Bonds you can purchase--that if you're a very large investor, it might be difficult to build a significant bulwark against inflation because the purchase limits are lower.

Bryan: That's right. So, for I Bonds you're allowed to purchase up to $10,000 per year. So that can be quite limiting if you're looking to protect a large portion of your portfolio.

Benz: You've brought a couple of ETFs that you like that invest in Treasury Inflation-Protected Securities. One that you like is Vanguard's short-term TIPS fund--an ETF. Let's talk about why you like it and why you think the short-term product can make sense in some instances.

Bryan: Yeah, so this fund basically invests in TIPS bonds with up to five years until maturity, and I think that makes it a really good hedge against inflation because changes in the Consumer Price Index reflect effectively short-term inflation. And short-term interest rates tend to be more closely tied to short-term inflation than longer-term interest rates. So, I think short-term TIPS can actually provide a closer hedge against changes in the CPI than longer-term TIPS.

I think this does a really good job of providing really cleaning exposure to short-term inflation. So, I think that's a really important point. The other point here is that with this fund, you're not taking a lot of interest-rate risk. You're certainly not taking, you know, any credit risk because these bonds are backed by the full faith and credit of the U.S. government. These are very low-risk bonds, very conservative bonds. So, if you're looking to preserve your purchasing power and you want something that's really closely tied to changes in the Consumer Price Index, I think it's really hard to beat short-term TIPS. And it's really hard to beat this Vanguard fund because it's one of the lowest-cost options for getting exposure to this part of the yield curve.

Benz: Another fund that you like--this is more of sort of broad-spectrum TIPS fund. This is Schwab US TIPS ETF. Let's talk about that one, and where you think that could fit and what sort of time horizon you'd want to have in mind if you owned a product like this one.

Bryan: So this one invests in TIPS kind of across the maturity spectrum--so, anything with at least one year to maturity. So it goes all the way out, owning some long-term TIPS. That inclusion of some of those longer duration bonds tends to give it a higher yield than the short-term fund that we just talked about. But that also introduces some additional risk, right? Because now this fund tends to be more sensitive to interest-rate changes.

Also longer-term interest rates don't move as closely in line with short-term inflation as shorter-term rates. So, the value and the change in the value of this fund may not be as closely tied to what's happening with short-term inflation as what's happening with the short TIPS fund.

But I think if you're a long-term investor and you don't need to necessarily access that principal for a while, I think this could be a really good option for earning additional yield compared to the short-term TIPS product. And you still get that purchasing power adjustment--the same way that the short-term TIPS work--you still get an increase in the coupon payments that you receive based off of the changes in the Consumer Price Index.

The only real difference here is that the principal value of your investment is going to fluctuate a bit more with longer-term TIPS, but you will be compensated in the form of higher yield over time. So, I think this is a good option if you're a bit more comfortable with risk and you're looking to earn a little bit more yield.

Benz: Alex, always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.