It has been said that it is not just inflation that is damaging, but unexpected inflation. After all, if inflation could be accurately predicted, there would not be the subtle transfer of wealth between parties to agreement (ex-lender and borrower). In the U.S., unexpected inflation helped spawn the creation of government issued inflation protected securities, called Treasury inflation protected securities (TIPS).

TUTORIAL: All About Inflation

Because inflation can be so damaging - and so unexpected - investors should have some portion of their fixed income portfolios in TIPS to ensure a "real return", but they are only part of the solution. This article will review the history and mechanics of TIPS, explore a few underlying components of TIPS operations that may leave the investor with a TIPS letdown and look briefly at an economic controversy that may help the investor think differently about protecting the real return of his or her portfolio.

History and Mechanics of TIPS
In the late 1990s, the U.S. Treasury followed the lead of several other governments in creating a real return, or inflation-adjusted, bond. Bond holders have always faced many risks to the return of their principal and interest, and the creation of TIPS sought to reduce inflation risks for Treasury investors. (For related reading, see What You Should Know About Inflation.)

It is important to realize that the adjustment mechanism that is used by TIPS is based on the Bureau of Labor Statistics' (BLS) Consumer Price Index for all Urban Consumers (CPI-U) headline inflation figure. As such, it includes the historically volatile components of food and energy prices. According to "Investment Analysis & Portfolio Management" (2002), a book by Frank Reilly and Keith Brown, because inflation is generally not known until several months after the fact, the index value used has a three-month lag built in. For example, for a bond issued on June 30, 2003, the beginning base index value used would be the CPI value as of March 30, 2003. Following the issuance of a TIPS bond, its principal value is adjusted every six months to reflect the inflation since the base period. In turn, the interest payment is computed based on this adjusted principal, that is, the interest payments equal the original coupon times the adjusted principal. (To learn more, read The Consumer Price Index Controversy and The Consumer Price Index: A Friend To Investors.)

CPI-U's Issues
With a better background into the indexing system used in the payment of TIPS interest, the investor needs to shift focus to how CPI-U is calculated; after all, its calculation determines whether your TIPS payment truly matches the increase in prices that may occur as a result of inflation.

Owner's Equivalent Rent
It is easy for investors to take the released CPI figures for granted, trusting that the BLS knows best how to measure inflation. Therefore, just how complicated the task of calculation actually is may come as quite a surprise. This is because there are many subjective aspects to putting the CPI together.

One very important example is that of the estimation of housing expense. Housing costs are the largest expense for many families, but the cost of housing is not a direct function of housing prices; it is based upon a creation called owner's equivalent rent (OER). Owners are queried periodically as to what level of rent they would charge to prospective tenants. Housing's proportion in the makeup of CPI is greater than 25%, so these numbers play a big role in the final CPI-U reading.

Treatment of Quality Improvements
Another rather subjective aspect of CPI-U calculation is that there is no mechanism for measuring quality improvements in the products and services that are in the marketplace. Furthermore, the BLS (through its retailer rotation practice) might measure an uptick in the price index if the new store carries the exact same product at a higher price. The assumption here is that the consumer has benefited by a non-price factor; the customer is assumed to have received better service in exchange for the higher price.

CPI: Overstated or Understated
Some argue that CPI overstates inflation, and thus understates economic growth via the following relationship: Nominal GDP - Inflation = Real GDP. Others believe that CPI understates some of the more subtle aspects and costs that inflation's mere presence introduces.

Steven Horwitz, in his article "The Costs of Inflation Revisited" (The Review of Austrian Economics, 2003), introduces two broad categories of inflation's costs: one results in direct costs, the other he terms coping costs. The direct costs include the errors made by investors and corporate managers due to uncertainty over the true value of a dollar. Coping costs involve the fact that CPI does not account for the time resources that are spent by investors and corporate managers trying to deal with, or compensate themselves for, inflationary effects. Horwitz introduces the example of individuals directing time toward hiring and meeting with financial professionals to form financial strategies, which are needed, in part, because of inflation. The same principle applies to corporate managers in the management of their treasury dollars and cash balances. While these concepts highlight inferred, rather than discrete, costs, the idea is that extra inefficiencies are created within the market outside of changes in interest rates.

Investors should diversify their inflation coping methods. While the use of TIPS may be part of the solution, it may also be advisable to employ other methods and instruments, such as commodities, metals and managed futures, which may provide further diversification for the investor's portfolio.

To learn more about TIPS, read Treasury Inflation Protected Securities.

Related Articles
  1. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  2. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  3. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  4. Active Trading

    10 Steps To Building A Winning Trading Plan

    It's impossible to avoid disaster without trading rules - make sure you know how to devise them for yourself.
  5. Economics

    Understanding Donald Trump's Stance on China

    Find out why China bothers Donald Trump so much, and why the 2016 Republican presidential candidate argues for a return to protectionist trade policies.
  6. Mutual Funds & ETFs

    Best 3 Vanguard Mutual Funds for Retirement

    Discover the top Vanguard target-date retirement funds with target dates in 2020, 2030 and 2050, and learn about the characteristics of these funds.
  7. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  8. Fundamental Analysis

    Top Private Equity Bargains for Your Portfolio

    Investing in private equity firms can lead to long-term profits.
  9. Fundamental Analysis

    Boost Your Portfolio by Adding 3 Turnaround Stocks

    Peter Lynch loves turnarounds. The stocks of these battered companies can offer incredible rewards if bought at the right time.
  10. Markets

    Are EM Stocks Finally Emerging?

    Many investors are looking at emerging market (EM) stocks and wonder if it’s time to step back in, while others wonder if we’ll see further declines.
  1. How do you make working capital adjustments in transfer pricing?

    Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
  2. Are Canadian Pension Plans inflation-protected?

    The Canada Pension Plan protects pension holdings against inflation and adjusts its annual rates for inflation. The Canada ... Read Full Answer >>
  3. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
  4. When is the best time to invest in inflation-protected securities?

    Investment timing decisions are among the most challenging faced by investors as they have a significant impact on ultimate ... Read Full Answer >>
  5. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  6. Should I include inflation-protected securities in my 401(k)?

    One of the most significant challenges faced by 401(k) account owners is the creation of an investment plan that can withstand ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center