Latest / Inflation and Your Money with Fexingo: Protecting Purchasing Power and Beating Inflation / How Inflation Is Quietly Eating Your TIPS Bond Returns
Transcript
- Lucas: So gold just hit $4,133 an ounce, up 3 percent in the last five days. Silver's up 7 percent. The CPI is down a bit, core CPI is basically flat, and the 10-year breakeven inflation rate is sitting at 2.26 percent — up from 2.25 yesterday. So what does a rational investor do right now? Luna: Load up on TIPS? I mean, that's the textbook inflation hedge, right? Treasury Inflation-Protected Securities — the principal adjusts with CPI. Lucas: It is. And for this episode I want to talk about why TIPS might actually be quietly eating your purchasing power, not protecting it. Because there's a gap between what the brochure says and what the net return looks like after taxes, after fees, and after you account for what you gave up by not owning something else. Luna: Okay, that's a strong claim. Walk me through it. Lucas: Let's start with the mechanics. A 10-year TIPS today yields about 1.8 percent real — that's the yield above inflation. Sounds fine. But the inflation adjustment to the principal is taxed as ordinary income in the year it accrues, even though you don't get that cash until maturity. That's the phantom income problem. Luna: Right, so if inflation is 3 percent and your principal goes up 3 percent, you pay tax on that 3 percent this year even though you didn't actually receive it. Lucas: Exactly. In a 24 percent federal bracket — plus state, say 5 percent — you're losing roughly 29 percent of that inflation adjustment to tax. So your net real return after tax is maybe 1 percent or less. And that's before you pay any management fee if you're in a fund. Luna: And the breakeven is 2.26 percent right now. So the market is pricing in that inflation will average about 2.26 percent over the next decade. If you believe that, TIPS are giving you maybe 1.8 percent real before tax. Lucas: Right. And historically the S&P 500 has returned about 6 to 7 percent real. Even after a lost decade or two, the gap is enormous. So the opportunity cost of holding TIPS for a long-term investor is huge. Luna: So who actually should own TIPS? Because they're still popular — there's over a trillion dollars outstanding. Lucas: They make sense in two narrow scenarios. First, if you're a retiree who absolutely cannot tolerate a drawdown in nominal terms and you need to match a known liability in real terms — like a long-term care cost. Second, if you expect inflation to be significantly higher than the breakeven, say 4 or 5 percent, then TIPS become a great bet. But right now the breakeven is 2.26, and the Fed funds rate is 3.63. That's not screaming 'inflation breakout'. Luna: And yet gold is at $4,133. Silver at $60. The market is pricing in something. Maybe the bond market is wrong? Lucas: Could be. There's a real debate right now. Some people say the government's CPI methodology understates true inflation — that if you use the old methodology from 1990, CPI would be closer to 5 or 6 percent. If that's true, TIPS are a screaming buy. But if CPI is accurate, TIPS are a poor long-term hold. Luna: Let me play this out with a concrete example. Say I put $10,000 into a 5-year TIPS ladder five years ago. What do I have today? Lucas: Let's say the average real yield was around 0.5 percent back then — because yields were really low. Inflation averaged about 4 percent over those five years. So your principal adjusted up about 22 percent cumulatively. But you paid tax on that phantom income each year. At a 24 percent bracket, you lost roughly 5.3 percent of your principal to taxes over the five years. Your net real return after tax might be around 1 to 2 percent total. Meanwhile, a simple S&P 500 index fund returned about 80 percent over the same period. Luna: Ouch. So the gap is enormous. But that's an unfair comparison — stocks are riskier. Lucas: It is unfair in terms of risk. But it's the comparison most retail investors implicitly make. They think 'I need inflation protection, I'll buy TIPS' without thinking about what they're giving up. And if inflation stays moderate, TIPS underperform both nominal bonds and equities over a long horizon. Luna: So if not TIPS, what? I Bonds? Gold? Real estate? Lucas: I Bonds are better for small amounts because the tax is deferred and you can avoid state tax. But you can only buy $10,000 per year. Gold has no cash flow and has high volatility in real terms over long periods. Real estate is great but illiquid and requires active management. The truth is, there's no perfect inflation hedge. The best hedge is probably a diversified portfolio with a heavy equity tilt, some real assets, and a willingness to adjust your spending when inflation surges. Luna: And that's the thing. If today's conversation made you rethink whether TIPS belong in your portfolio, or if you just found the tax angle useful, that's the kind of practical insight we try to deliver every day. Lucas: Yeah, and the way these episodes stay free and ad-free is through listener support. If you got something out of this, you can buy us a coffee at buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash f-e-x-i-n-g-o. It's not required, but it helps us keep doing the deep dives without selling your attention. Luna: Absolutely. And we appreciate every single person who listens. Now back to the numbers — because I want to look at the breakeven rate more closely. It's 2.26 percent today. That's up from 2.25 yesterday. But it's down from 2.5 a year ago. What does that trend tell us? Lucas: It tells us the bond market expects inflation to moderate over the next decade. The Fed has held rates at 3.63 percent for over a year now, and that's starting to work. But the real economy is still running hot in some areas — services inflation, for example, is sticky around 4 to 5 percent. So the bond market might be too complacent. Luna: And if the bond market is wrong and inflation stays at 3 percent, TIPS would outperform nominal Treasuries by about 74 basis points per year. But after tax, that advantage shrinks. Lucas: Right. And the other risk is that the Fed might cut rates if the economy slows. If the Fed cuts, nominal bonds rally in price, but TIPS might not rally as much because real yields could stay flat or rise. So TIPS have less upside in a disinflationary scenario. Luna: So the real question for listeners is: what's your personal inflation rate? Your spending basket might be very different from the CPI. If you're a renter in a hot city, your inflation is higher than the national average. If you're a homeowner with a fixed mortgage, your inflation is lower. Lucas: That's a great point. The CPI is an average. Your mileage will vary. And TIPS only protect against official CPI. If your personal inflation is 5 percent but CPI is 2 percent, TIPS are actually losing you purchasing power in real terms. So you have to think about your own situation. Luna: I think the takeaway is: TIPS are not a set-it-and-forget-it solution. They're a tactical tool for specific scenarios. If you're not in one of those scenarios, you might be better off with a diversified portfolio that includes equities, some commodities, and maybe a small allocation to I Bonds. Lucas: Exactly. And if you are considering TIPS, look at the after-tax real yield. Not the advertised real yield. Run the numbers with your own tax rate. That's where the rubber meets the road. Luna: Alright, I think we've given everyone a lot to chew on. Next time we'll talk about whether the Fed's next move is a cut or a hold — and what that means for your bond portfolio. Lucas: Looking forward to it. For now, keep an eye on that breakeven rate and your personal inflation. Thanks for listening.