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TIPS and deflation

Chris Farrell Dec 1, 2008

Question: I called my broker to buy some TIPS. He told me to be very careful because they could lose value in a deflationary environment. Is this true? Steve, Minneapolis, MN

Answer: Not really. To be fair, some people use the term “deflation” to mean a trend toward a lower rate of inflation. And in that environment regular Treasury bonds will likely outperform their TIPS peers. But the trend toward lower inflation is what economists and Wall Street financiers call “disinflation.”

Deflation is another matter altogether. It is the mirror image of inflation. Deflation is a fall in the overall price level. Inflation is an increase in the overall price level.

U.S. Treasury inflation protected securities (better known as TIPS) are default-free securities that protect the investor from the ravages of inflation. The inflation-indexed bonds come in 5, 10 and 20 year maturities. All offer a fixed interest rate above inflation as measured by the consumer price index (CPI). The bond’s principal is adjusted as the CPI changes. I’m a big fan of TIPS since they offer a safe haven in times of trouble and they make sure that the value of a dollar saved today is worth a dollar–plus some interest–5, 10, and 20 years from now.

But here’s an additional advantage of TIPS: They also offer owners protection against deflation. TIPS come with a “deflation floor” that protects the holder’s principal value if the depression scare turns into a deflationary episode. In other words, if the Consumer Price Index is falling the floor guarantees the TIPS owner either the inflation-adjusted principal or the par value at maturity–whichever is greater. TIPS do not lose their value during deflation.

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