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Navigating Inflation: Conventional Bonds Vs. TIPS Investment Strategy

31 July, 2023

Investors often allocate a portion of their savings to Treasury bonds, but the question remains: should you opt for conventional bonds or Treasury Inflation Protected Securities (TIPS)? Your choice will largely depend on your faith in the Federal Reserve’s ability to maintain an inflation rate of 2%.

For those who trust the Fed’s capacity to manage inflation, traditional Treasury bonds may be the best fit. These bonds typically yield around 4% and are a staple in many investment portfolios. However, if you harbour doubts about the Fed’s inflation control, you may want to consider TIPS. These securities offer a yield of approximately 1.7%, plus the rate of inflation.

Inflation could exceed 2% by the time your bond matures, making TIPS a potentially more lucrative investment. In this article, we will delve into the merits and drawbacks of both conventional bonds and TIPS, and explore other options for hedging against inflation.

Starting with conventional Treasury bonds, it’s important to dispel the myth that they are risk-free. Long-term bonds, in particular, carry significant risk. Although they guarantee par value at maturity, their prices fluctuate in the interim, leading to potential losses.

Conventional Treasury bonds are susceptible to two primary risks: unexpected inflation and an unanticipated increase in the real rate (the inflation-adjusted rate). Both scenarios can result in higher nominal bond yields and lower bond prices. This was evidenced last year when long-term Treasury bonds suffered significant losses.

TIPS, on the other hand, mitigate the risk of unexpected inflation but are still vulnerable to increases in real rates. Last year saw real rates on ten-year TIPS rise from -1% to +1.6%, leading to a similar downturn.

The choice between conventional bonds and TIPS for your retirement account depends on your expectations for inflation. If you anticipate low inflation, conventional bonds would be more beneficial. Conversely, if you expect high inflation, TIPS would be the better choice. Given the unpredictability of economic conditions, diversifying your portfolio is a prudent strategy.

Wealth Enhancement Group, a Minneapolis-based firm managing $67 billion in assets, advocates for portfolio diversification. Chief Investment Officer Jim Cahn believes that while nominal-rate bonds should not be avoided entirely, investors should be prepared for potential disappointments in the Fed’s inflation management.

Cahn suggests a diversified approach that includes equities as a hedge against inflation, along with allocations to TIPS, commodities, and a Lord Abbett institutional fund linked to the Consumer Price Index.

Another form of diversification involves varying bond durations. Duration measures a bond’s sensitivity to interest rate fluctuations and is closely related to maturity. If you expect rates to rise, short-duration bonds would be more suitable. If you expect rates to fall, long-duration bonds would be ideal. Since future interest rates are uncertain, diversifying across different durations is recommended.

In conclusion, whether you’re investing in conventional bonds or TIPS, diversification is key. Just as gym marketing strategies benefit from diversity (incorporating elements like Facebook ads and gym lead generation), so too does your investment portfolio. A mix of different bonds and durations can help mitigate risk and maximize returns.

Whether you’re investing directly or through ETFs, it’s important to consider costs. All recommended funds have low expense ratios relative to their categories. For larger investments ($100,000 or more), direct bond purchases can offer even better deals with minimal middleman costs.

In summary, both conventional bonds and TIPS have their merits and drawbacks. Your choice should align with your expectations for inflation and your risk tolerance. Diversifying across different types of bonds and durations can help manage risk and optimize returns – much like advertising for gyms benefits from using multiple channels to attract more gym members.