Ignore your bond portfolio’s greatest enemy at your own peril. Inflation may not have been much of a concern for municipal bond investors in recent years, but it could well be in the cards now.
Why is inflation growth more likely today? A probable decline in federal corporate and personal tax rates alongside Trump’s trillion-dollar infrastructure program. Simply put, that means falling federal revenues and increased federal spending, which together create an inflationary environment. There are other reasons the market expects rising inflation, such as decreased regulation.
And if inflation is on the horizon, fixed-income investors should be looking at ways to shield the value of their investments.
ONE WAY TO HEAD OFF INFLATION
The most common and direct way to get inflation protection is to buy Treasury Inflation-Protected Securities (TIPS). TIPS provide inflation protection by adjusting the face value of the investment by the inflation rate and then paying interest on that adjusted face value. For example, a TIPS with a $1,000 face value and a 1.5% coupon will pay $15 in annual interest. If inflation is 2%, then the value is adjusted to $1,020 and the annual interest increases to $15.30.
TIPS have done their job this year, outperforming Treasury securities when inflation expectations have risen, as they did in the first and third quarters and in the fourth quarter to date (Display 1).
The advantage of TIPS’ structure is that investors keep up with inflation and are offered a real rate of return. The disadvantage is that, for investors who pay taxes, TIPS are notoriously tax inefficient. The interest on the underlying TIPS is taxed at ordinary income tax rates, and so is the inflation adjustment. But here’s the kicker. The inflation adjustment is received when the TIPS mature, but is taxed in the year in which it was realized. That makes it “phantom income.”
Thankfully, for investors who are subject to taxes, there is a more tax-efficient form of inflation protection.
