Two-Sided TIPS

By Barbara Kiviat

With wholesale prices rising briskly and consumer costs creeping up, investors are rushing to protect their money from inflation. This season's favorite hedge: Treasury inflation-protected securities, or TIPS, which do what their name suggests and provide great portfolio diversification to boot. The bad news is that investors have been clamoring for TIPS so enthusiastically that they have bid up prices, making TIPS less attractive for the time being.

Here's how TIPS work: principal and interest payments of TIPS, unlike ordinary Treasury bonds, are adjusted for inflation--when goods and services become more expensive and your dollar winds up buying less. Say you put $1,000 into TIPS, and inflation (as measured by the consumer price index) rings in at 2.5%. At the end of the year, you would have a face value of about 2.5% more, or $1,025. (If consumer prices drop, so does the face value, but never below your original investment.) The tradeoff is that TIPS carry lower interest rates than ordinary Treasuries. The 10-year benchmark Treasury recently yielded 4.72%, while the 10-year benchmark TIPS yielded just 1.99%. You come out ahead with TIPS only if their yield plus the inflation rate is greater than the Treasury yield over the time you hold the bonds.

At the moment, TIPS may not be the best buy. As inflation worries have gathered steam over the past year, investors have rushed to buy TIPS, driving up prices and bringing down yields. At current yields, inflation would have to average 2.73% over the next 10 years just to make the 10year TIPS break even with the standard Treasury. Many money managers doubt that inflation, which currently sits at 2.3%, will get that high in the near term. "I would look for a better entry point," says Wan-Chong Kung, who helps manage $10 billion in bond funds at U.S. Bancorp Asset Management. She recommends that tactical investors wait for prices to come down and for the yield spread between 10-year TIPS and Treasuries to narrow to 2.25% to 2.5%.

But if your philosophy is buy and hold and your investing horizon is long term, you may not want to wait because TIPS provide portfolio diversification. TIPS have a low correlation with the performance of stocks and even other bonds. And that means a less risky portfolio overall. Thomas Grzymala, a certified financial planner in Keswick, Va., keeps around 7% of his clients' portfolios in TIPS--about what most advisers recommend.

If you do decide to dip into TIPS, you'll find more choices than ever. Even though the $200 billion TIPS market represents a small fraction of all government debt, TIPS have come a long way since their low-key 1997 rollout. The Treasury is on track this year to issue about $60 billion worth of TIPS, double last year's issuance, as part of an effort to diversify liability and attract new investors. In July the Treasury will auction new 20year TIPS and in October will follow up with a five-year note. You can buy TIPS from the Treasury directly (at treasurydirect.gov or through your broker. If possible, keep TIPS in a tax-sheltered account like a 401(k) or IRA. While TIPS are free from state and local taxes, you do get taxed each year at the federal level on semiannual interest payments and gain in principal, even though those amounts are automatically reinvested.

Another option is to buy a TIPS mutual fund. As the TIPS market balloons, fund firms are responding. There are about 20 offerings to pick from. You should look for a fund with at least a few years' track record as well as low expenses and above-average returns. Eric Jacobson, a senior analyst at fund tracker Morningstar, recommends Vanguard Inflation-Protected Securities and Fidelity Inflation-Protected Bond. And for fans of exchange-traded funds, which trade like stocks, there's iShares Lehman TIPS Bond Fund. Funds that buy TIPS are conservative investments. But don't forget that even they can lose money if interest rates go up and bond prices fall. Alas, the protection perk gets you only so far.