NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesMedium
A client approaches an investment adviser with concerns about the impact of inflation on their fixed-income portfolio. Specifically, they are worried that rising inflation will erode the purchasing power of their bond interest payments. Which of the following investment strategies would be most effective in mitigating this specific risk?
- AIncreasing allocation to high-yield corporate bonds
- BInvesting in Treasury Inflation-Protected Securities (TIPS)
- CInvesting in long-duration government bonds
- DShifting to a higher allocation of preferred stocks
Show answer & explanationAnswer & explanation
Correct answer: B. Investing in Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) are specifically designed to protect investors from inflation. Their principal value adjusts with the Consumer Price Index (CPI), and the interest payments are then paid on the adjusted principal, ensuring that the purchasing power of the investment is preserved.
Why the other options are wrong
- A. High-yield corporate bonds carry higher credit risk and are not directly structured to protect against inflation's erosion of purchasing power.
- C. Long-duration bonds are more sensitive to interest rate risk, which often rises with inflation, thus exacerbating the problem.
- D. Preferred stocks are equity-like but have fixed dividends, making them susceptible to inflation's negative impact on purchasing power.
Treasury Inflation-Protected Securities (TIPS)
Government bonds whose principal value is adjusted periodically based on changes in the Consumer Price Index (CPI), providing protection against inflation.
- Principal value adjusts with inflation.
- Interest payments are then paid on the adjusted principal.
- Issued by the U.S. Treasury.
Memory trick: TIPS are the best 'tip' for inflation.