Inflation-Protected Securities (IPSs)

Inflation-protected securities (IPSs) are designed to be among the safest investments on the market. These securities have two sets of interest rates. The first is the market rate for the investment. The second interest rate moves at the rate of inflation. As a result, the effect of inflation will never reduce the earnings on your investment. This option is particularly intriguing on low-interest securities like Treasury bonds. Despite the arguments for IPSs, though, there are still some downsides.

Risk of Inflation on Investment

Inflation constantly threatens to undercut the gains of an investment. Even if you earn 5 percent on an investment over a three-year period, which is a relatively high return, you will fail to see much profit if inflation climbs at a rate of 3 percent. This is particularly a problem in a bull market, when investment profits could be highest. As the market climbs, prices on goods tend to rise due to an increase in spending and demand. To cover for this risk, some securities use a second interest rate determined by the Consumer Price Index or a similar metric. The rate of inflation is added to the the rate of return.

Low-Risk Investments Particularly Exposed

The risk of inflation undercutting an investment is particularly high on a low-risk investment. Low-risk investments tend to have relatively low profit margins. Investors surrender some earning potential in exchange for the safety of a definite increase. If inflation rises faster than this increase, though, the low-risk investment may actually net a loss. As a result, low-risk securities are more likely to offer inflation protection to investors. 

Treasury Inflation-Protected Securities (TIPS)

Perhaps the most common example of an IPS is the Treasury Inflation-Protected Security. This government bond is marketed as the safest investment possible. First, it is backed by the United States Treasury, removing any risk of default from the investment. In exchange for this ultimate security, investors surrender high interest rates for low, stable growth. The Treasury can boast the low risk of this option only if inflation is not a constant threat to earnings. As a result, the par value of a TIPS bond goes up with the rate of inflation, and the secondary interest rate is added on top of this par value. It is virtually impossible, then, to lose any money on a TIPS purchase. This makes the TIPS bond a good option to balance a mutual fund portfolio or save for retirement.

Disadvantages of Inflation Protection

The inflation adjustment on any IPS goes both ways. This means, in a period of deflation, the interest rate on the bond will actually decrease. Deflation rarely occurs, however, so this is a low risk. A much more likely reality is that an investor will fail to recognize his or her true earning potential by sticking with investments that are far too safe. While owning some TIPS or private IPSs is a good idea, building a winning investment strategy should include some risk. Without risk, the rate of return will not increase the investment to a level much above a traditional savings account.

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