By Eric Rosenberg, WCI Contributor

If you’re looking at fixed-income investments, you may be considering TIPS vs. nominal bonds. TIPS are a form of Treasury bond that’s protected from inflation, while nominal bonds are conventional bonds with no added inflation protection. While inflation protection from TIPS might sound like a better investment, they are not always the best choice. Here’s a closer look at TIPS vs. nominal bonds to help you understand which may be best for your investment goals.

 

What Are Nominal Bonds?

Most people think of nominal bonds when shopping for bonds for their portfolios. With nominal bonds, sometimes called conventional bonds, the investor buys the bond knowing all terms upfront. Bonds are essentially a loan to a company or government. With nominal bonds, you’ll typically get a periodic interest payment over the life of the bond and get your initial investment amount back on the bond’s maturity date.

In most cases, individual investors don’t buy individual bonds. Instead, they put assets into a bond fund, which represents a wider bond market array.

 

Nominal Bond Example

Here’s an example of a nominal bond to better understand how they work:

Company Z is raising $100 million to expand its manufacturing capacity. To fund the expansion, it offers 10,000 bonds at $10,000 each. Based on the company’s exceptional AAA rating, the interest rate is set at 4%.

On the issue day, investors, mainly mutual fund and ETF managers, snatch up all of the bonds with an expected 4.6% annual return. If they hold the bonds until maturity, they will earn a predictable 4.6% return, paid as a $100 quarterly coupon totaling $400 per year.

After a year, market interest rates increase following interest rate increases by the Federal Reserve. With the interest rate increase, newly issued AAA Bonds earn 5%, a full percentage point more per year. With higher rates for new bonds, the value of the older 4% bond goes down on the secondary market, as bond buyers expect the same 5% yield to maturity (YTM). With that expectation, the bond is now worth $8,475 if sold.

The owner can keep the bond and continue earning 4% interest. But if they need to sell the bond for cash, they’ll incur a loss on the bond’s principal.

 

Pros And Cons of Nominal Bonds

Pros

  • Earn a predictable fixed interest rate through maturity
  • Ability to resell on the secondary market
  • Bond values rise when interest rates fall

Cons

  • Holding periods may lock up funds for decades
  • Bond values fall when interest rates rise
  • No protection against inflation

More information here:

Why I Hate Total Bond Market Index Funds

Should I Hold Bonds In My Portfolio? Here’s Why I Don’t

 

What Are TIPS?

TIPS is an acronym for Treasury Inflation-Protected Securities. As the name suggests, TIPS are issued by the United States Treasury. As a United States government bond, they’re considered extremely safe and one of the lowest-risk places to put your money.

With TIPS, the bond's face value increases with inflation, following the Consumer Price Index (CPI). If the CPI indicates an annual inflation rate of 3%, the face value of the bond increases by 3%, and subsequent coupon payments are 3% higher. However, as a government bond, the starting interest rate is likely low compared to company bonds and other higher-risk investments.

It’s also important to note that TIPS can lose value if the inflation rate is negative (deflation), but that’s extremely rare.

 

TIPS Example

An investor buys $10,000 of 30-year TIPS bonds in a recent public auction. The interest rate is locked in at 3%, and the bond pays a quarterly coupon of $75, adding up to $300 per year. Inflation is 3% the following year, so the bond’s principal value rises to $10,300. Going forward, the interest payment is $309 per year ($77.25 quarterly), which is 3% of the bond’s new face value.

However, the bond still pays a 3% yield to maturity. If market interest rates drive the value of TIPS to 4%, the value of the currently held 3% security goes down. To get the same 4% yield to maturity they’d get with new bonds, secondary market investors are willing to pay just $8,290 for the same bond.

 

Pros and Cons of TIPS

Pros

  • Protection from high inflation rates
  • Very safe government-backed securities
  • Predictable payments that typically grow over time

Cons

  • Lower interest rates than higher-risk corporate bonds
  • Face values fall when market interest rates increase
  • TIPS historically underperforms compared to stocks

 

Comparing TIPS and Nominal Bonds

When looking at TIPS vs. nominal bonds, these major differences may lead you to choose one over the other:

tips vs nominal bonds

 

Risk

For risk, TIPS are generally considered far less risky than corporate bonds and are on par with other government bonds. The US Treasury issues many types of bonds, and TIPS have virtually identical risks. However, even the highest-rated corporate bonds are often thought of as riskier than government securities.

 

Interest Rate

As government bonds with low risk, you’ll usually get among the lowest interest rates in the bond markets from US government bonds, including TIPS. As credit ratings decrease, interest rates increase. “Junk bonds,” higher-risk nominal corporate bonds, often pay among the best interest rates in the bond markets.

 

Exposure to Market Interest Rates

When market interest rates change, the face value of TIPS and nominal bonds rise and increase together. There’s no significant difference between the two.

 

Exposure to Inflation

Inflation slowly eats away at the effective return of nominal bonds as the principal and coupon payments become worth a little less every year. TIPS, on the other hand, moves in lockstep with inflation. TIPS don’t lose any value to inflation alone.

More information here:

I Bonds and TIPS: Which Inflation-Indexed Bond Should You Buy Now?

 

TIPS vs. Nominal Bonds: The Bottom Line

There’s no perfect place for everyone to invest. For most medical professionals considering TIPS vs. nominal bonds, nominal bonds are a clear winner. Unless you’re extremely worried about inflation and think interest rates will decrease, your market predictions make nominal bonds a better choice.

With higher initial interest rates and relatively little benefit from the increase in value from inflation, you’ll likely come out ahead with nominal bonds, assuming they have a higher initial interest rate. Most doctors have a high enough income to afford to take the slightly higher risk.

However, bonds may not be right for your portfolio. Consider the pros and cons of bonds vs. stocks and other potentially more compelling investments, too.

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