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As inflation hedge, TIPS can offer a protected harbor

  • Article by: CHRIS FARRELL
  • October 6, 2012 - 4:54 PM

QA few years ago, you'd suggested TIPS index as an alternative to the complete bond index. Do you still feel that way?

DREW

AYes, I still like Treasury Inflation Protected Securities (TIPS). Inflation -- an overall rise in the price level -- erodes the value of savings over time, a real problem for anyone investing for the long haul. Creditworthy inflation-indexed U.S. Treasury bonds are a quality hedge against inflation. TIPS offer savers a fixed interest rate above inflation, as measured by the Consumer Price Index.

Of course, these days you could ask "what inflation?" Ever since the Federal Reserve embraced quantitative easing and other extraordinary measures to shore up the economy, critics have charged that high and rising inflation was coming. Yet so far inflation has been dormant. The Consumer Price Index over the past 12 months has risen at a 1.7 percent annual rate.

Even more striking are market-based, forward-looking measures of inflation. For example, one way to gauge investor expectations of inflation is to look at the difference between conventional 10-year Treasury yields and the yield on inflation-indexed 10-year TIPS. The gap suggests investors are anticipating inflation will average about 2.4 percent over the next 10 years -- hardly a scary number.

Still, TIPS offer a hedge against the risk that inflation will turn out to be higher than expected. Buying TIPS at the moment is a controversial strategy because the government has been auctioning off TIPS at a negative yield with strong investor demand. I still think owning TIPS is reasonable since the negative yield is essentially an "insurance premium" paid for the inflation hedge. The higher the inflation rate ends up the more valuable are TIPS -- and vice versa. That's the nature of a hedge.

Buying TIPS from the government during an auction and holding them until the bond matures is the good strategy. This way, you lock in a risk-free, inflation-adjusted real rate of return. For tax reasons, TIPS are best held in a tax-sheltered account. However, buying TIPS at auction isn't always an option or the best choice for individual investors. It's why I recommend TIPS index funds -- both mutual funds and exchange traded funds. They're convenient and fees are often low.

Like all bond funds, the net asset value of the TIPS fund will fluctuate with changes in interest rates There is less of a match with inflation. Still, an inflation-index fund is less risky than a conventional (not inflation-indexed) bond fund. The fund will still give you a measure of protection against rising prices.

"Future inflation is highly uncertain, so the riskiness of conventional bonds is greater than that of TIPS," says Zvi Bodie, professor of finance at Boston University and co-author of "Risk Less and Prosper: Your Guide to Safer Investing.''

For anyone interested in learning more about TIPS, I'd read Bodie's book, especially the chapter titled "Finding the Safe Investment Zone." TIPS are a complicated security and the authors go into detail about TIPS, the trade-offs to think through before buying, and other inflation-indexed options. I also like the personal finance perspective that informs the book.

Chris Farrell is economics editor for "Marketplace Money." His e-mail is cfarrell@mpr.org.

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