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| Risk & Reward |
Inflated Expectations
John Ferry
09/01/2005
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Tips Tax Trap
One significant downside to Treasury Inflation Protected Securities (TIPS)
is their tax treatment. The investor’s overall income stream from TIPS consists
of the coupon payments, made every six months, and the principal repayment at
maturity. Both of these increase when inflation, measured by the CPI-U, rises.
Unfortunately, the IRS takes an aggressive approach to taxing the gains. George
Oberhoffer of Russell Investment Group explains: “The U.S. tax authorities tax
the coupon payment that you receive and also the increase in principal value due
to inflation, not when you receive it at maturity, but at the time that the
principal amount is grown. So an increase in inflation actually has adverse tax
consequences for a taxable investor.” Perversely, increases in inflation that
should benefit the holder can actually cause him to suffer a negative return
before maturity due to the need to pay tax.
Because of this, investment
experts say that the best way to invest in TIPS is via a tax-deferred account.
“If the investment is not held in a tax-deferred vehicle then you could have
negative cash flows in the short term, because the taxes that you have to pay on
the principal, which you don’t get back until maturity, are going to more than
offset the coupons that you receive every six months,” says Bill Irving, a
fixed-income portfolio manager at Fidelity Investments in Merrimack, N.H.Nature of the Beast
Most investors can be forgiven for viewing the concept of hedging inflation
as purely academic. After all, uncontrolled price rises have not been a problem
since the 1980s. Many believe that policymakers have a handle on the issue. But
history shows that inflation eventually rears its head after a long period of
stable growth, as happened when the hyperinflation of the 1970s followed on the
heels of a golden period of expansion in the 1960s.
John Brynjolfsson of
Pimco says economic policymakers are often loath to address inflation in its
earliest stages because doing so is almost always painful. It generally involves
either raising interest rates—which hurts both stock and bond markets—or cutting
government spending to take some of the wind out of the labor market. Neither is
politically popular and can result in significant pressure on even nonpolitical,
insulated entities such as central banks.
Another reason to doubt the
government’s resolve, according to Paul Greff of State Street Global Advisors,
is that the massive U.S. current account deficit now makes some degree of
inflation attractive to policymakers because it lowers the real value of foreign
(and domestic) claims on the country. Demographic trends that are inexorably
leading to growing unfunded liabilities and a situation in which older consumers
will outnumber younger producers might spur the government to allow inflation to
run around 5 percent for an extended period of time, he adds.
So while the
leading economies have been enjoying consistently low inflation for the past
decade, there are pressures that may cause it to reemerge. Investors may want to
take a proactive role in hedging themselves against the risk, rather than rely
solely on the government to keep it in check. As Brynjolfsson says: “Fighting
inflation is not everyone’s favorite thing.”
John Ferry is an Edinburgh, U.K.-based journalist who specializes in writing
about financial markets and investments.
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