One way to help protect your portfolio against a sudden spike in inflation is by investing in Treasury Inflation-Protected Securities (TIPS).
TIPS are guaranteed by the federal government as to the timely payment of principal and interest. They are sold in $100 increments and available in maturities of 5, 10, and 30 years. The principal is automatically adjusted twice a year to match any increases or decreases in the Consumer Price Index (CPI). If the CPI moves up or down, the Treasury recalculates your principal.
A fixed rate of interest is paid twice a year based on the current principal, so the amount of interest may also fluctuate. Thus, you are trading the certainty of knowing exactly how much interest you’ll receive for the assurance that your investment will maintain its purchasing power over time.
TIPS pay lower interest rates than equivalent Treasury securities that don’t adjust for inflation. The difference between the yield of nominal bonds and inflation-linked bonds with similar maturities is called the breakeven inflation rate. It is the cost for inflation protection and a market-based measure of expected inflation. If you hold TIPS to maturity, you will receive the greater of the inflation-adjusted principal or the amount of your original investment; this provides the benefit of keeping up with inflation while protecting against deflation. Considering that there has been some inflation every year over the past 60 years, the principal of TIPS held to maturity is likely to be higher than when they were purchased.1
The return and principal value of TIPS on the secondary market fluctuate with market conditions. If not held to maturity, TIPS may be worth more or less than their original value. They are also sensitive to movements in interest rates. When interest rates rise, the value of existing TIPS will typically fall. Because headline CPI includes food and energy prices, TIPS can also be affected by volatile oil prices.
Unless you own TIPS in a tax-deferred account, you must pay federal income tax each year on the interest income plus any increase in principal, even though you won’t receive that money until they mature.
1 U.S. Bureau of Labor Statistics, 2017 (data through December 2016)