Must-know: Implications of inflation and the necessity of TIPS

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Implications of inflation

An increase in inflation and inflation expectations would increase the required rates of return on both stock (IVV) and bond (BND) investments, irrespective of the Fed’s monetary policy stance.

Part 3

Both the popular measures for inflation, the Consumer Price Index (or CPI) and the change in Personal Consumption Expenditure (or PCE) have been increasing over the past three months. While the real rate of interest compensates savers and lenders for risks arising from the time value of money, default risk and other systematic risks, it doesn’t cover inflation risk. Inflation risk is the risk of erosion in the value of an investment due to an increase in the price levels.

The CPI report for June, which released on Tuesday, July 22, showed that prices increased 2.1% on a year-over-year (or YoY) basis. Core inflation—inflation excluding the more volatile food and energy components—came in at 1.9% on an annualized basis.

Producer price inflation increased by 0.4% month-over-month (or MoM) in June, compared to market estimates of 0.3%. Although the higher-than-expected increase was largely energy-related, producer price increases would trickle down to consumers as well.

Due to these factors, domestic bidder demand edged up in the July 24 auction for Treasury Inflation Protected Securities (or TIPS).

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When price levels in the economy increase, the purchasing power of the dollar also reduces—the same amount of dollars would buy you a lesser quantity of goods in the future than in the present. Inflation also benefits borrowers to the detriment of lenders because the real value of the principal and interest payments gets eroded due to inflation.

U.S. Treasury introduced TIPS in 1997

In order to eliminate inflation risk for investors, the U.S. Treasury introduced TIPS in 1997. TIPS protect the value of debt securities from eroding due to inflation. The principal of a TIPS is indexed to the CPI. This implies that the TIPS principal increases with inflation and decreases with deflation. On maturity, you would be paid the greater of the adjusted principal or original principal amount of the TIPS.

The coupon payments on TIPS are applied to the adjusted principal. As a result, the coupon payments on TIPS provide the bondholder with a fixed amount of purchasing power. Exchange-traded funds (or ETFs) providing exposure to TIPS include the iShares TIP Bond ETF.

Generally, commodities like gold (GLD), silver (SLV), and energy provide good hedges against inflation. So does real estate (VNQ) to an extent. The SPDR Gold Trust ETF (GLD), the iShares Silver Trust (SLV), the S&P GSCI Crude Oil Total Return Index ETN, and the Vanguard REIT ETF (VNQ) are some of the ways you can gain exposure to these investments.

52-week Treasury bills auction

In the following section, we’ll discuss the 52-week or one-year Treasury bill (or T-bill) auction held last week. Please continue reading the next section in this series.

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