I mentioned yesterday that, based on the experience of the years from 1926 to 1999, the safest possible place for money you planned to hold 5 years was a blend of 55% in cash (well, Treasury bills or money-market funds) and the rest split equally between U.S. and international stock portfolios. The worst you would have done in any 5-year period was a “real” rate of return (after inflation but before taxes) of minus 2.35% per year.
Losing 2.35% a year for five years turns $10,000 into $8,879. Not too awful for a worst-case scenario.
But what if I offered you a deal with a GUARANTEED POSITIVE return of 4.25% per year above inflation, exempt from state and local income taxes, and with no risk of default? Would you turn it down? Well, millions of people just did, in the January 2000 auction of Treasury Inflation-Protected Securities (TIPS).
Consider this: over long periods of history, stocks offer real returns of around 7% (after inflation but before brokerage or mutual fund fees, expenses and commissions, and before tax). To get that, you have to endure a roller coaster that periodically cuts your investment in half and requires great staying power. Most people, through commissions, annual mutual fund expenses, bad market timing, big allocations to cash or bonds for safety, and foolish short-selling (I was so dumb!), do considerably worse than 7% after inflation.
So why not settle for a completely safe and simple 4.25% above inflation? Why aren’t people falling in love with TIPS? I have some theories:
(1) They don’t know about them or understand them.
Okay, let me solve this one first. TIPS are sold in auctions by the Treasury in multiples of $1,000 and then trade regularly until maturity. The bidding is for the cash yield (as I said, the last auction produced a 4.25% yield). This yield is paid on the face value of the bonds semi-annually (2.125% per six months for the January 2000 10-year TIPS), just like other Treasury notes and bonds. The difference is that the face value is adjusted automatically for changes in the Consumer Price Index for Urban Consumers (CPI-U). So both the face value and the interest payments are going to go up with inflation (and down with deflation if we should have it, though never below the original face). Your real return to maturity is guaranteed.
(2) They think the government might change the way the CPI is calculated.
I understand this fear, since many believe that the CPI-U overstates inflation by 0.5% to 1.5% per year, and there is now an alternate CPI-U being computed that supposedly is more accurate. People who are suspicious of everything the government does are convinced they will switch to the alternate method and reduce the returns of these bonds considerably. But even my libertarian friend, the estimable Less Antman, who says, “I wouldn’t trust a government report that said the Sun was going to rise in the East tomorrow,” says that can’t happen, because THERE IS SPECIFIC LANGUAGE IN THE LAW FORBIDDING IT. The rules for TIPS say specifically that any change in the computation of the CPI-U that reduces reported inflation from the old method requires the yield on these be increased to compensate.
(3) The periodic increases in face value are taxed immediately, even though the face value isn’t payable until the bond matures.
It’s true, it’s a bummer, and it was probably a mistake for the Treasury to design it this way. Unfortunately, if you buy a 30-year TIPS, after 1 year you’ll be taxed on a cash flow you’re not going to collect for another 29 years.
There are two points to be made here. First, if you hold TIPS in retirement accounts, this is not relevant. The appreciation won’t be taxed until withdrawn anyway. Second, the premise of this discussion was that we were looking for a safe 5-year return — not 30. The effect of being taxed a few years early is not that significant. (It could even save you money if you’re headed for a higher tax bracket, or if receiving that extra taxable income all at once, in the fifth year, would have bumped you into a higher bracket.)
Also, if you’re using TIPS in a custodial account for your teenager, the taxation will be pretty small.
Nevertheless, the government blew it here. If you own a $1,000 TIPS with a 4% yield and we have 3% inflation, you’ll receive a bit more than $40 in cash but be taxed on a bit more than $70. For the average person in the 28% bracket, that works out to around $20 in tax payments, or 50% of the current yield. If inflation gets really bad, you could actually owe more taxes than the entire yield, with years or decades to wait for recovery (and a probable drop in the market price if you want to sell early).
And a footnote to the retirement-account solution to the tax problem is this minor but annoying little twist. Namely, that TIPS, being Treasury securities, are meant to be free of state and local income tax. Yet if you own them inside a retirement plan, they will be taxed, when you withdraw them, like any other retirement dollars you withdraw from the account — as ordinary taxable income.
Finally, since I can hear a bunch of you muttering this under your breath, let me spare your having to write angrily to tell me that the government has no right to tax inflation gains in the first place, because they’re not real gains at all! Hey — makes sense to me. I would be perfectly happy to have TIPS designed to adjust for inflation tax-free. That would make them even more desirable, driving down the rate of interest Uncle Sam would have to pay to attract buyers. It might thus not wind up costing Uncle Sam a penny, yet boost their popularity and simplify things. Thanks for writing in to tell me that.
(4) There aren’t any 5-year TIPS.
Okay, you got me there. They tried, though. The Treasury offered 5-, 10-, and 30-year TIPS in 1997, and the sales of the 5-year notes were so miserable they discontinued them (but the 1997 issues are trading in the market and you can buy TIPS maturing in 2002 through your broker). They only sell the 10-year TIPS in January and July and the 30-year TIPS (too long for anything but tax-deferred accounts) in October. Having started in 1997, that means the earliest 10-year TIPS issued in January 1997 are coming due in January 2007, a little under 7 years from now. Obviously, within 2 years we’ll have a steady supply of TIPS that can be bought on the open market with maturities in 5 years (though they probably won’t still be yielding over 4% once people get wise to these). And except for the commission you’ll pay on sale and the tiny discrepancy that might exist between the face and market value of these when you sell (not likely to exceed 1%, and more likely to be a gain than a loss, anyway), a TIPS maturing in 2007 should be reasonable for a 2005 goal.
You’ll have to use a broker to buy a TIPS that is already trading, but can buy new 10- and 30-year TIPS at the auctions directly (even in an IRA) without commissions — or on-line. http://www.publicdebt.treas.gov
So far, there’s one mutual fund specializing in them, the American Century Inflation-Adjusted Treasury Fund, which was founded immediately after these were created, but it is a mark of their unpopularity that the fund still isn’t large enough to have been assigned a ticker symbol! It has a 0.51% expense ratio (not unreasonable for such a tiny fund) that is scheduled to drop when people start piling in.
Also, I believe Vanguard is launching a bond fund to invest in inflation-indexed securities in a few weeks. It looks like TIPS aren’t going to remain a secret for much longer
But before you act on any of this, give me one more day, because there is one other investment that may be even better than TIPS, especially for retirees or those saving for an older child’s upcoming college education.
Monday: 5-year TIPS without taxation