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What Are TIPS And What Is Happening In That Part Of The Fixed Income Market?

Treasury bonds are one of many different types of fixed income available. Find out what they do and how that particular investment vehicle is responding to today’s market environment.

Transcript

Tim Maurer
Hello, Tim Maurer. We’re back with another episode of Ask Buckingham. A new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s thought leader is Blerina Hysi, fixed income trading manager at Buckingham Wealth Partners. And Blerina, of the high quality fixed income varieties. One of the more confusing to me is TIPS. What exactly are TIPS and what’s happening right now in that particular genre of fixed income?

Blerina Hysi
Yes, Tim and TIPS are definitely very confusing because they’re not as straight forward as every other bond where they have a face value, a coupon payment that whether you’re buying at a premium or a discount, mature at par. There’s a lot more moving parts to it. One of the major differences between a TIPS position and a treasury position is that the fact that it has an inflation factor built into it. This inflation factor will move based on inflation and deflation. So what that does to your principle value is that it will either increase it or decrease it on whatever the inflation is doing.

Blerina Hysi
So to give you an example, if we do run into a deflationary period and you have a two percent coupon, let’s say, that principle value will actually fall below par, which means that your cash flow of two percent will be less because it will be two percent of whatever the value is, which could fall below that par value.

Tim Maurer
So Blerina, in what denominations does one by TIPS, for example. Let’s just walk through what a practical TIPS purchase might be and how an investor would see the investment respond. If I wanted to buy TIPS, where do I go and how much should I buy?

Blerina Hysi
So there’s a couple of ways to buy TIPS as well as treasuries, you could go and buy them through TreasuryDirect. So any retail investor could go and buy directly to the treasury or you could have them in your brokerage account and have your money manager purchase them for you. They sell as low as a 100 bonds per minimum, which is actually below that one bond, which we consider a $1,000 worth. So you can spend a $100 on a TIPS position that’s essentially, mechanically is going to show 0.1 in your account. We don’t recommend that. There’s not too many dealers that want to transact below that one bond minimal. So I say anytime you want to purchase a TIPS position, you want to buy at least one bond or above, which is essentially spending roughly about 1,000 give or take what that inflation is doing as well as interest rates.

Blerina Hysi
Because with TIPS there’s two moving parts. You have the inflation factor that’s going to change your principle value as well as interest rates. And we know with interest rates movements your prices go up and down. So the two of them will change the principal value depending on which direction each one is going.

Tim Maurer
Okay, so if I was to say buy $10,000 worth of TIPS, what could I expect there? Would it have a particular interest rate associated with it?

Blerina Hysi
It will have an interest rate that’s going to fluctuate throughout the life of that position. Depending on how much of a premium or a discount you’re paying for that bond, your 10,000 could buy you a different face value. Then based on your face value, that’s where the coupon payment is calculated. As well as adding that factor which is going to reflect inflation and deflation. So throughout the life of your TIPS position, your cashflow is going to be different because it’s going to be adjusted every time based on inflation and deflation.

Tim Maurer
Okay. So how often is that interest rate payment adjusted?

Blerina Hysi
You get your interest payment every six months, but the adjustment is done on a daily basis.

Tim Maurer
So what do you think about TIPS? Is it something that investors should be considering buying now or if not, when are the environments that you think that these are the most helpful?

Blerina Hysi
So TIPS are definitely a great tool to protect against unexpected inflation. A lot of that inflation is already priced into the TIPS position. So as these traders are selling TIPS, they are assuming a certain inflation factor built into it. What an investor is protecting against is that unexpected inflation. What if things were to go a different direction and we have this uptick in inflation. How do you protect yourself? And the best way to do that is by having TIPS exposure. There’s a couple of things to consider there.

Blerina Hysi
One of them, and the most important one is, what is the equivalent product to buy instead of TIPS? And when we are building portfolios for Buckingham, we typically go to CDs and comparatives position to CDs. Sometimes we see a big difference between the two. So what that’s telling us is that even if we assume an unexpected inflation. That inflation would have to be significantly higher for us to break even between a CD and a TIPS position. So the way we approach it is, let’s pick up this nominal yield that the CDs paying us and we have so much cushion to protect against unexpected inflation. Now that’s all based on the client’s likeliness to be okay with unexpected inflation.

Blerina Hysi
So if you do have a client that’s truly terrified of unexpected inflation and they don’t care to pick up that additional yield that CDs are offering, then use this almost as an insurance policy. You pay the premium to have your protection against unexpected inflation. If nothing happens, you lose that premium. If you do run into that unexpected inflation, then you are protected in that sense.

Tim Maurer
So I guess it depends A, on what’s happening in the fixed income markets and then it depends, most importantly on the ability, willingness and need of each individual to actually purchase these securities, yes?

Blerina Hysi
Correct, and you have to keep in mind that the federal government has been trying to keep inflation at about two percent for a while. Unlike that the treasury market prior to the volatility in March was pricing inflation at about 1.55%. Then the volatility in March happened and it dropped that inflation expectations to 0.22%. So very drastic drop there. As things started to stabilize, we have seen it come up at roughly at about 80 basis points, but it’s still far from the two percent target that the federal government has been trying to accomplish for awhile.

Tim Maurer
And could we anticipate that that trend will continue for a while yet, as we’re continuing to see the crazy situation with COVID-19?

Blerina Hysi
There’s a lot of uncertainty there. So some of it is pricing, but it is very hard to tell which direction the economy is going to go. It’s all going to depend on how long this is going to last. How much of an impact this is going to have on the economy.?

Tim Maurer
Well, thank you Blerina for straightforward answer and not making any prognostications. And thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com or by emailing your question to question@askbuckingham.com. Or take it easy on yourself and just click in the corner of the stream. It’ll take you directly to the website. Remember that there are no dumb questions per se, but unfortunately, there are plenty of poor answers out there. Our hope is that in giving you straight answers to your questions, it will bring a sense of calm and allow you to apply what you’ve learned in pursuit of good decision making. So please follow us. And by all means, Ask Buckingham.

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Meet your guests.

Tom Bodin
Tom Bodin
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Vince Crivello
Vince Crivello
Head of the Practice Management Group

As head of the Practice Management Group at Buckingham, Vince helps lead client experience design initiatives, oversee consulting and training programs, and provide key industry insights to advisors.

Aaron Grey
Aaron Grey
Director of Planning Integration

As the director of planning integration at Buckingham, Aaron helps advisors develop, implement, monitor and update wealth management strategies in pursuit of their clients’ financial goals.

Kevin Grogan
Kevin Grogan
Managing Director, Investment Strategy

Guided by academic research, Kevin Grogan, Director of Investment Strategy, oversees our overall strategy and helps clients and advisors alike distill complex investing topics. 

Jared Hoffman
Jared Hoffman
Managing Director, Relationship Management

As Managing Director at Buckingham, Jared provides education on best practices around cybersecurity. He is a member of Infraguard, a partnership between the FBI and public sector created to share information on cybercrime.

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Blerina Hysi
Fixed Income Trading Manager

As fixed income trading manager, Blerina helps construct and maintain customized bond portfolios, all with an eye toward finding the best way to implement the client’s comprehensive financial plan.

Mike Kenneally
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Jared Kizer, CFA
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Jeffrey Levine
Jeffrey Levine
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Michael O'Neal
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Irv Rothenberg
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Jonathan Scheid
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Meir Statman
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Research Advisor

Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University. His research focuses on how investors and money managers make financial decisions and how these decisions are reflected in financial markets.

Susan Strasbaugh
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Larry Swedroe
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