Here's a 'TIP': Time to get ready for inflation
In these times of market turbulence, might you consider an investment that offers 100 percent principal protection and a gain that could surpass 20 percent?
Have I got a deal for you!
This investment is in … (hold your breath) … TIPS! (Treasury Inflation Protected Securities). And it is an investment that many advisors are telling you to avoid like the plague since they currently bear a very low yield.
Don't believe them.
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Here's the logic. Let's start by comparing the 10-year TIPS to the 10-year Treasury bond.
Same creditor—Uncle Sam. The difference in yield between these two securities is roughly 2 percent; the 10-year Treasury has a yield of about 2.7 percent and the TIPS bond has a yield of 0.65 percent, hence a difference in yield of about 2 percent. (This relationship fluctuates.)
What these prices are telling us is that the market believes that inflation will be about 2 percent a year over the next 10 years, so the 10-year Treasury is yielding roughly 2 percent higher than the comparable TIPS whose value is adjusted for inflation.
How about you?
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Do you believe that inflation will be higher than 2 percent over the next 10 years? I sure do, and if you agree, logic dictates that you should own the TIPS rather than the nominal.
Once you own the TIPS, there are three possible scenarios:
• First, rates go up and inflation goes up. In this scenario, TIPS will outperform nominal Treasury bonds since if rates go up, inflation is likely to go up and Uncle Sam will add principal to the TIPS to adjust for the inflation. In fact, if there is a spike in inflation, we could be looking at a double digit gain in the value of the TIPS. TIPS wins.
• Second, interest rates go up and inflation goes down. In that case, Treasury securities win, but how likely is that?
• Third, rates stay relatively low while inflation goes up. This is the Fed's preferred scenario and if it comes true, TIPS will outperform Treasurys.
Stock and bond markets have been volatile in recent times. Investors are confused and worried.
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They don't have to look far for relief. It isn't often that we can find an investment with secure principal protection and a hefty upside potential, but TIPS today meet that standard.
The U.S. government will guarantee repayment so there's no downside risk, and if interest rates go up sooner rather than later, as many expect they will, this safe investment could produce a whopping return.
Yet most investment pros are telling you to stay away!
Instead, investors should have a look at their portfolios and for the fixed income portion, stay away from long-term bonds which will decline in value as interest rates rise, and consider TIPS which will dampen portfolio volatility and just might deliver a hefty bonus if interest rates and inflation spike.
—Peter J. Tanous is president of Lepercq Lynx Investment Advisory in Washington and author of numerous finance books, including Debt, Deficits and the Demise of the American Economy, with CNBC's Jeff Cox.