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January 24, 2017

“Risk free” Investing

TIPS May Be the Answer

Someone I know is coming into a moderate sum of money and asked me how he can invest it “risk free”. He was very clear that he isn’t looking for gain on the investment, just safety; so, although no investment can be truly free of risk, given some assumptions it’s a very reasonable question. However, if you act on my answer, you are doing so entirely at your own risk.

Although it may sound contradictory, the main question for a risk-intolerant investor is what risks ARE you willing to tolerate. For example, I know that my advisee is investing in US dollars. He does care if these dollars lose purchasing power (inflation) but doesn’t care if the dollar declines against any other currencies so long as his purchasing power at home is not affected. He is willing (I think) to accept the risk that the US government will default despite having a president very versed in “restructurings”. A very important risk he is willing to take – and you may not be – is that, if he needs the money sooner than he thought he would, his investment will NOT have been risk free; he may take an actual loss.

OK, with all that out of the way, what I think my advisee should do is buy TIPS – Treasury Inflation-Protected Securities. These are interesting bond issued by the US Treasury which protects against loss of purchasing power. Like most bonds it pays a fixed interest rate which is determined by auction at the time of issue; the interest rate is fixed for the life of the bond, which may be 5, 10, or 30 years. What is not fixed is the principal amount of the bond; that is adjusted daily based on inflation – more precisely on “the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U) published by the Bureau of Labor Statistics of the U.S. Department of Labor.”

Here’s what this means: suppose you buy $1000 of these things at auction with an interest rate of 0.375% (yes, this is low) and a maturity date 10 years from now; $1000 is your ORIGINAL principal amount. Each day the Treasury calculates the ration between the CPI for that day and the CPI for the day your bond was initially sold at auction. This adjustment affects both the dollars of interest you receive at each semiannual interest date and, most importantly, the principal you receive back when your bond matures.

You really don’t care about that index on a daily basis so let’s skip forward 10 years to when you are going to cash in your bond. If the CPI has increased 50% over that ten years (used to happen all the time), you will be repaid $1500. You haven’t really made a profit; your purchasing power is still the same as $1000 had when you invested it. But you did almost protect against inflation. The “almost” part comes from the fact that Uncle Sam wants income tax on the $500 nominal gain; since it is a federal bond, it doesn’t pay state or local income tax.

If there was no inflation as measured by the CPI, you will get back just the $1000 you put in. You’ll still have the same purchasing power you started with (and you won’t owe any tax because you had no nominal gain).

But suppose there’s deflation. Most economists will tell you that doesn’t happen long term but experts are often wrong, especially lately. Suppose the CPI is at 75% of where it was when your bond was auctioned. You still get back 100% of the principal you put in. You will have an actual (untaxed) gain in purchasing power. Of course most bonds promise to pay back 100% of the principal so can be considered to include deflation insurance. But most bonds don’t protect you against inflation. From my PoV, this is a free lottery ticket that comes with TIPS – but my advisee isn’t out to make money, just wants to protect what he has; so we’ll ignore this now that I mentioned it.

The inflation adjustment to your principal also affects the interest payments you receive semiannually. For example, If the CPI is cumulatively 1% higher six months after you bought your bond than it was on auction day, your principal will have been adjusted up by 1% to $1010 dollars and interest will be paid on that adjusted principal; you will receive $1.89375 ($1010 x .00375/2) instead of the $1.875 ($1000 x .00375/2) you would have received had there been no adjustment. “Whoopee!” you say, “big deal”. But remember, we’re in this for safety and not income. However, there is no ratchet in the interest calculation. If deflation were to take place, the dollars of interest you earn could go down.

Like any bond, if you want to sell your TIPS before they mature, no one is guaranteeing that you’ll get your principal back. You sell them on an open market. If the rate of inflation has accelerated, you’ll probably lose money. If it’s decelerated, you may gain.

TIPS are a really boring investment. But they may be right for you if you are willing to forgo future gain in return for safety – at least on part of your portfolio. If you want to buy them, you can get them directly from the Treasury at auction. See here for instructions. You can also get them through a bank or broker but check the commissions; you’re not earning much on this asset. If you’re a sophisticated investor, you may want to buy or sell on the secondary market – but in that case you don’t need my advice.

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