Summary TIPS represent only 10% of the Treasury market but should play a larger role in diversified portfolios. TIPS protect bond investors against unexpected inflation while capping deflation risk. Only TIPS can provide an inflation hedge, the prospect of real returns, and the safety of the backing of the U.S. Treasury. We’ve written several articles in the past about what investments and asset classes shouldn’t be in your portfolio, such as commodities , currency funds , and bank loan funds . We also wrote a few articles about asset classes that should be in your portfolio, such as international bonds . But we’ve never discussed how to assemble a comprehensive, well-diversified portfolio. It’s important to note we are talking about an investment portfolio so we will not be considering cash which would be part of someone’s savings portfolio. In this ongoing series of articles, we’ll be discussing each of the asset classes we use to assemble client portfolios. Over the next few weeks, we’ll be discussing each asset class in depth and talking about what risk and reward attributes they bring to a portfolio. For this series of articles, we’ve divided the asset classes into three conceptual categories: low risk, medium risk, and high risk. The links to previous articles are below. Low Risk Treasury Inflation Protected Securities (( OTC:TIPS )): Why TIPS Deserve a Spot in Your Portfolio Domestic Government Bonds Medium Risk High Risk Real Estate Domestic and International Stocks Summary How to Assemble a Comprehensive Investment Portfolio What are Treasury Inflation Protected Securities or TIPS? Treasury Inflation Protected Securities or TIPS are a relatively recent invention having only been issued by the U.S. Treasury since 1997. TIPS represent a small minority of the Treasury securities market, with only about a 10% market share, but we believe they could play a much bigger role in investors’ portfolios. Like the name suggests TIPS are designed to protect investors from unexpected rises in inflation by adjusting the income and principal investors receive when inflation changes. How TIPS Work TIPS function just like normal bonds but with one key difference. Like a traditional bond, a TIPS bond pays a fixed percentage coupon and the investor receives the par value of the bond back at maturity. However, TIPS protect investors against inflation by adjusting the par value of the bond upwards when inflation rises. The coupon payments also increase since they are based on the new, higher par value of the bond. Inflation data is calculated using the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U) index published by the Bureau of Labor Statistics. The inflation data is calculated every six months when the TIPS pay interest (like most bonds, TIPS make interest payments twice per year). To see how this works, let’s look at a hypothetical TIPS bond that has a par value of $1,000 and pays a coupon of 2%, and then what happens after a year that sees 10% inflation. For simplicity’s sake, we are going to just pretend TIPS pay interest once per year while in reality they make two coupon payments each year (each one being one-half the calculated interest rate). Year Inflation/Deflation Par Value Coupon Rate Coupon Payment Initial Year n/a $1,000 2% $20 Second Year 10% inflation $1,100 2% $22 As you can see in the table, the 10% increase in inflation increases the par value of the bond by 10% or $100. The coupon is 2% of the new par value of $1,100 or $22. Now, an important thing to take note of is that this process also works in reverse. If inflation, as measured by CPI-U, is negative, then the par value of the bond will decrease. However, the value will never drop below the initial par value the bond was issued at (in this case $1,000). To see how deflation affects TIPS, let’s take the same example we used above but now add a third year where we have 5% deflation. The table below shows what will happen. Year Inflation/Deflation Par Value Coupon Rate Coupon Payment Initial Year n/a $1,000 2% $20 Second Year 10% inflation $1,100 2% $22 Third Year 5% deflation $1,045 2% $20.9 The par value of the bond is reduced from its previous value of $1,100 by 5% to $1,045. The coupon rate as always stays the same at 2% and the new coupon payment is 2% of the new par value of $1,045 or $20.90. It’s also important to note that the fluctuation of the par value of TIPS will have an effect on the taxes an investor pays. An investor will be liable for taxes on the adjustments to the par value of the bonds. Increases in the par value of the bonds are treated as interest income in the year the increases occur, even though the investor may only receive the increase in par value years in the future when the bond comes due. For example, if an investor received $2,000 in interest and the par value of the bonds rose $500, then the investor would be taxed on $2,500 of income ($2,000 in interest plus a $500 increase in par value). Likewise, decreases in the par value of the bond due to deflation are treated as reductions in interest income. For example, if an investor received $2,000 in interest payments but the par value of the bonds dropped by $500, the investor would only be taxed on $1,500 of income ($2,000 in interest minus $500 reduction in par value). What TIPS Can Add to Your Portfolio We’ve spent almost the last decade in an environment of very low to no inflation so TIPS may seem like they provide little value. In fact, we’ve basically been in a period of falling inflation and falling interest rates over the past few decades which have been great for traditional bonds. But the recent past is certainly not an indication of the future. The chart below shows the year-over-year change in the inflation measure used by TIPS (CPI-U). As you can see, inflation has been much more volatile in the past. Unexpected, high inflation is the exact type of risk that TIPS are designed to protect investors against. In periods of unexpected rising inflation, TIPS behave the opposite of normal bonds. If inflation were to rise unexpectedly, the fixed coupon payments of traditional Treasury securities would become less valuable in real terms. Investors would demand higher interest rates and the price of bonds would fall. With TIPS, both the coupon payment and the par value of the bond would be adjusted upwards to match inflation. TIPS also benefit from the fact that inflation below expectations (remember all bonds have inflation expectations built into them in the form of what interest rates investors demand) or deflation will only reduce the value of a TIPS bond down to its par value. Thus, losses due to negative inflation adjustments are effectively capped. TIPS offer investors unlimited inflation upside and limited deflation downside. It’s virtually impossible to find any other type of investment with capped downside and unlimited upside risks in respect to inflation. The Case for TIPS over Other Hedges While TIPS certainly aren’t the only type of inflation hedge out there, they are one of the best. Specific types of stocks can be good inflation hedges. Stocks of companies that have significant pricing power and strong brands, the stereotypical example of cigarette companies come to mind, can provide a powerful hedge against inflation. They also come with the higher risk and volatility that comes with all stocks. Commodities are often cited as providing a hedge against inflation. However, as we showed in two of our previous articles last year ( here and part two here ), over the long term, commodities have only provided a hedge against inflation. They offered no real return above inflation. Also, as recent events have shown, commodities can be quite volatile as well. TIPS offer investors a hedge against inflation, the opportunity for real returns, and the safety of the backing of the U.S. Treasury. No other asset class can offer that combination to investors and that is why TIPS should play an important role in any diversified portfolio. Investors can purchase TIPS directly from the U.S. Treasury or via any number of ETFs or mutual funds, a few of which are shown in the table below. Fund Name (Ticker) Expense Ratio iShares TIPS Bond ETF .20% Vanguard Inflation-Protected Securities Fund (MUTF: VIPSX ) .20% Schwab U.S. TIPS ETF (NYSEARCA: SCHP ) .07% SPDR Barclays TIPS ETF (NYSEARCA: IPE ) .15% Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long TIP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.