"Owning individual TIPS offers an investor the ability to place an inflationary hedge with a greater degree of customization," he says.
Rick Kahler, president of Kahler Financial Group in Rapid City, South Dakota, says individual TIPS make sense for people building a bond ladder to fund a specific goal.
However, he offers a couple of caveats to that advice.
"You need to consider taxes and the complexity of the bond," he says. "There is no bond more complex than a TIPS."
When TIPS are held in a non-retirement account, they are taxed annually in 2 ways:
- On their accumulated interest.
- On the amounts that have been added to the principal as part of the inflation adjustment.
The latter levy is widely described as a tax on "phantom income," and it can result in a higher tax bill each year if you hold TIPS in a taxable account, says Wan-Chong Kung, CFA, a Minneapolis-based senior vice president and portfolio manager with Nuveen Asset Management.
"You will need to pay federal taxes on accumulated inflation that is used to increase your principal amount, even if you do not receive the principal adjustment until maturity," she says.
Because of how TIPS are taxed, most advisers recommend holding them only in a retirement account, where annual taxes can be deferred (as in a traditional IRA) or eliminated (as in a Roth IRA). The most practical way to purchase individual TIPS in an IRA is through:
- A bank.
- A discount brokerage firm.
- A fund firm with a discount brokerage arm, such as Vanguard, Fidelity or Charles Schwab.
You can ask a broker to purchase individual TIPS on your behalf, although this often requires you to pay a fee. Many mutual fund firms also allow you to purchase these securities directly online, fee-free.
Kung also notes that the periodic interest payments associated with TIPS are not automatically reinvested. To keep these amounts inflation-protected, you will need to earmark them for the purchase of future individual TIPS.
Time to avoid TIPS?
Despite the potential advantages of purchasing individual TIPS in an IRA, Kubik has advised clients to avoid TIPS while inflation remains under control.
"If market conditions shift and we foresee high levels of inflation, (TIPS) could very well be one of the inflationary tools that we would use to create a hedge," he says.
Samuel Scott, president at Sunrise Advisors in Leawood, Kansas, believes other asset classes, including other currencies, commodities, stocks and real estate, offer better inflation protection than TIPS.
He sounds a note of skepticism about how the government calculates inflation for the purpose of adjusting TIPS principal.
"The cynic in us thinks the government has an incentive to calculate CPI in such a way that minimizes outlays," he says.
Scott notes that CPI calculations have been adjusted over the years, and that when the government makes cost-of-living adjustments, "there is financial incentive to understate true inflation," especially in light of payments tied to those adjustments, such as Social Security obligations.
If your faith in the government's inflation calculations is a bit stronger, but you want to skip the hassle of buying individual TIPS, you can still purchase a TIPS mutual fund or exchange-traded fund.
Collins says a TIPS mutual fund still makes sense for many savers and investors, especially those who want a "less hands-on approach."
TIPS funds and ETFs require less work than individual TIPS because you can set them up to automatically reinvest their periodic interest payments.
If you are worried about interest rates rising, be careful about the type of TIPS mutual fund you purchase, Kahler says.
"I currently like the short-term TIPS bond funds, especially in an environment where interest rates are rising," he says.
Most TIPS mutual funds hold bonds with long maturities. As interest rates rise, the value of these bonds falls, which can impact a fund's overall performance.
Purchasing a TIPS fund that holds bonds with shorter durations gives investors a measure of protection when interest rates climb.