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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And as we all know, inflation has skyrocketed this year. In fact, inflation jumped to a 40-year high of 8.5% just two months ago. So why then are TIPS, aka Treasury Inflation Protected Securities, losing money? And what are TIPS exactly? And do they belong in a retirement portfolio? In fact, TIPS is a
If you want answers to these questions, you are going to love today's episode. For all the links and resources mentioned today, just head over to youstaywealthy.com forward slash 154. The Consumer Price Index Report, also referred to as the Monthly Inflation Report for the month of May here in 2022, is scheduled to be released tomorrow.
As a reminder, these reports come out monthly. So tomorrow on June 10th, we're going to be given the inflation data for last month, the month of May. But the headlines that most of us will see reflects the annual inflation rate measuring the 12 month time period from May of 2021 to May of 2022. In other words, the annual inflation rate that we see is kind of backwards looking.
For example, the April CPI report, the last report that we received, indicated that inflation was 0.3% or said more accurately that the consumer price index had increased by 0.3%.
But the annual inflation number, the 12 month number measuring April of 2021 to April of 2022 was 8.3%. And that 8.3% number is again, what most of us saw in the news, because let's be honest, a headline stating that prices jumped by 0.3% probably wouldn't generate the necessary clicks and eyeballs needed to generate meaningful advertising revenue for these media outlets.
Anyhow, it's possible that tomorrow's inflation report announcing that the consumer price index change for the month of May, it's possible that it will reveal a lower annual inflation number.
Instead of 8.3%, maybe we see something closer to 8% or 7.9%. I'm not really sure. And I haven't seen any intelligent forecasts that are worth sharing here. But again, since the annual inflation number that will make headlines is backwards looking across the previous 12 months...
It will be most interesting and most telling to isolate and look at the data just for the month of May to get a better sense of the current change in consumer prices across all the different categories. I'll be sharing these details and my thoughts next Tuesday here on the podcast, so be sure to tune in.
But even if we do see a positive report tomorrow and inflation does drop a little bit, it doesn't necessarily mean that the trend will continue. Things like the Ukraine war, China shutting down and surging commodity prices could cause more inflation or higher inflation in the very near future. On the other hand, rising interest rates, cooling off in the housing market, fiscal tightening, and maybe a recession looking more and more likely could push inflation lower.
While we don't know what inflation will do in the future, we know what it's done in the past. We kicked off 2022 with a January CPI report indicating a 7% year-over-year change in prices. In February, inflation jumped to 7.9%. And in March...
Inflation reached a four decade high of eight and a half percent. So why then are tips treasury inflation protected securities? Why are tips down approximately six percent this year if we're seeing inflation spikes that haven't been experienced in 40 years?
To answer that question, we first have to understand what tips are exactly, because I think the name can be a bit misleading or at the very least cause confusion. And I don't blame anyone for being confused here, because here's the definition straight from the U.S. Treasury website. It says tips provide protection against inflation. The principle increases with inflation and decreases with deflation as measured by the Consumer Price Index or CPI.
But as investors have learned this year, it's not quite that simple. CPI is up, but tips are down. So why is this? Let's dig into better understand. To start, like your traditional U.S. Treasury bonds, tips are issued by the U.S. government, and therefore they are AAA rated securities, the safest bonds that you can own.
But unlike traditional U.S. Treasury bonds, also referred to as nominal bonds, tips are adjusted for inflation, and this can cause the interest payments to vary. While these interest payments can and do fluctuate, the actual interest rate on tips is fixed, but
but that fixed rate is applied to the value of the bond and the value of the bond changes and adjusts to inflation. So if the principal value of the bond goes up due to rising prices, investors will receive a higher coupon payment. 5% multiplied by a principal amount of $1,100 is higher than 5% on a principal amount of $1,000. The
The interest rate didn't change, but the value of the bond did, which causes the interest payment to the investor to change. Another important thing to know is that tips can be purchased with 5, 10, or 30-year maturities. And when the bond matures, the investor will receive the higher of the adjusted principal amount or the original principal in addition to the interest earned along the way, of course.
You can also buy tips through a mutual fund or exchange-traded fund, which is typically the desired solution for most retirement investors. So to summarize, tips are U.S. government bonds that deliver after-inflation returns, aka real returns, whereas conventional U.S. treasury bonds, often referred to as nominal bonds, they provide returns before inflation.
And that difference is the primary reason why tips usually pay lower interest rates than nominal bonds. So with all this in mind, if you have a crystal ball, you would want to buy tips when you think inflation will be above market expectations in the future. And you would want to buy nominal U.S. Treasury bonds when you think inflation will be below future expectations. I'll say that again because it's the most important piece to answering today's question.
If you have a crystal ball, you would want to buy tips when you expect inflation to be above market expectations in the future. And you would want to buy nominal U.S. Treasury bonds when you expect inflation to be below future expectations.
And there is accessible data for investors to get kind of an aggregate view of future expected inflation, allowing them to put their crystal ball to the test if they're interested. One such data set would be accessed through the Survey of Professional Forecasters, which is published by the Federal Reserve Bank of Philadelphia. And I'll link to it in the show notes if you're interested. But
As noted by ETF.com, the survey of professional forecasters includes more than 50 economists from many of the leading financial and research institutions in the country. Their views help shape opinions about expectations for inflation. So that's one method. But another method for determining if tips make more sense than nominal bonds is what's known as the five-year inflation swap.
And I'm going to spare you the nerdy details here, and I'll just link to a few academic papers in the show notes if you want to dig into it. In addition to not wanting to put you to sleep here, the main reason for not getting into the weeds on these methodologies is that no matter what way you spin it, in my opinion here, we're making a prediction. We're making an active market timing decision to choose tips over nominal bonds.
Sometimes your prediction may be right and other times it may be wrong, which is primarily why the late David Swenson, Yale's longtime CIO who revolutionized endowment investing, is primarily why David advocated for cutting your allocation right down the middle, owning 50% in tips and 50% nominal U.S. treasury bonds behind the scenes.
in the bond sleeve of your portfolio. So if you have a 60-40 stock bond portfolio, well, according to him, 20% would be in US treasury bonds, nominal bonds, and 20% would be in tips. I've mentioned it many times before on the show, but Swenson's book, Unconventional Success, is one of my all-time favorite investing books.
And in the book, he lays out this philosophy in more detail. But if you don't want to read the book, it is quite long and dense. You can also just quickly Google the Swenson portfolio and you can get a quick breakdown of his model. I will also link to a couple articles in the show notes as well. So bringing us home here, why are tips losing money this year? Well, in summary, because the current environment has been in line with market expectations and
In addition to driving home the point that knowing when to buy tips versus nominal bonds is pretty much impossible, I also want to highlight that like all bonds, tips contain risk. They can be a smart addition to bond portfolios, but they are not risk-free as some get trapped into thinking. They are impacted by changes in interest rates and inaction taken by the Federal Reserve.
It's important to understand the risks and set proper expectations with this asset class or any asset class for that matter before investing your hard-earned money. And with an enticing name like Treasury Inflation Protected Securities and the deceptive definition on some of these websites, it's easy and it's common for people to have the wrong expectations when investing in tips.
Lastly, one final fun fact to take into consideration here is that tips are actually a relatively new asset class. They were first auctioned off in January of 1997. So we only have about 25 years worth of data compared to 100 or more years of data for most other major asset classes. For that reason, some might argue that we may need more data to determine with certainty the role that tips play in our retirement portfolios.
Once again, the show notes for today's episode can be found by going to youstaywealthy.com forward slash 154. Thank you as always for listening. And I'll see you back here next Tuesday, where we will dissect the May inflation report that's coming out tomorrow and attempt to make some thoughtful and informed observation for the year ahead.
