Asset allocation is powerful money management tool that determines the distribution of risky investments across broad asset classes-stocks, bonds, mutual funds, REITs, TIPSs, hedge funds, options, foreign assets, and so on. Once you build up your well-diversified portfolio, you should periodically adjust it to the current market condition, in order to take advantage of new investment opportunities that arise and react adequately to inflation.
Inflation is an enemy to investors. Investors usually pay closer attention to the nominal rate of return, but real rate of return (nominal interest rate – inflation rate) is the one that really matters. For example, if an investor buys a security with a 7% interest rate that matures in 5 years and the inflation has risen 3% for that time period, then the real rate of return would be 4%. All long-term securities get hit by inflation.
In the beginning of 1997, the United States Treasury introduced to the market a new type of securities called treasury inflation-protected securities (TIPSs), used as a risk-adjusted mechanism. TIPSs are considered low-risk investment vehicles because they are backed by the U.S. government. TIPSs hedge against inflation by paying not only regular interest rate, but also providing adjustments based on the inflation as measured by changes in the Consumer Price Index (CPI), during the security’s life. TIPS’s face value is also adjusted in accordance to inflation changes. Consider a five-year TIPS with a face value $1,000 and interest rate of 4%. Suppose that the inflation rate rises with 5% in the first year. Then the face value of the bond would be $1,050 (5% x $1,050) and the coupon payment would be $42 (4% x $1,050).
TIPS or Bonds
TIPS structure is quite similar to that of regular bonds and thus it is a difficult task to determine which security will perform better over time. An increasing rate of inflation does not necessary mean that TIPSs will outperform bonds. Assume a TISP with 4% real rate of return, and a bond with 7% nominal rate of return with the same duration. At maturity, if the inflation has not risen more than 3%, then the TIPS is not a better investment than the bond. However, there is another factor that must be taken into account- the coupon rate. If everything else equal, the annual coupon payment of a bond with a coupon rate of 7% is obviously much higher than the annual interest payment of a treasury inflation-protected security with an interest rate of 4 %, unless the inflation increases significantly.
hen designing your investment portfolio with a long-term strategic asset allocation approach, it is wisely to consider the impact inflation has over your long-term financial goals. Incorporating TIPS will result in a lower assets correlation and may speed up the wealth accumulation process. For additional information on this and related topics, check out Jim Fink’s recent report on Stock Diversification and Asset Allocation Strategies.