FINRA Series 7Investment Information and Suitable RecommendationsHard
A client owns a portfolio of blue-chip stocks and income-producing bonds. They are concerned about the potential for unexpected inflation eroding the purchasing power of their investments. Which of the following investments would be MOST effective in mitigating this specific risk?
- ALong-term U.S. Treasury bonds
- BFixed annuity
- CHigh-yield corporate bonds
- DTreasury Inflation-Protected Securities (TIPS)
Show answer & explanationAnswer & explanation
Correct answer: D. Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) are specifically designed to protect investors from inflation. Their principal value adjusts semi-annually based on changes in the Consumer Price Index (CPI), and the interest payments are then paid on this inflation-adjusted principal, effectively preserving purchasing power.
Why the other options are wrong
- A. Long-term U.S. Treasury bonds are highly susceptible to inflation risk, as their fixed interest payments lose purchasing power.
- B. Fixed annuities offer guaranteed payments, but these payments do not adjust for inflation, making them vulnerable to purchasing power erosion.
- C. High-yield corporate bonds are more sensitive to credit risk and interest rate risk, and do not offer direct protection against inflation.
Treasury Inflation-Protected Securities (TIPS)
U.S. Treasury bonds whose principal value is adjusted semi-annually based on changes in the Consumer Price Index (CPI), providing protection against inflation.
- Principal adjusts with inflation (CPI).
- Interest payments are paid on the adjusted principal.
- Designed to preserve purchasing power.
- Interest is federally taxable annually (phantom income), state/local exempt.
Memory trick: TIPS: Treasury Inflation Protection, Smart choice for Savings.