Inflation Tips Wanted

By Daniel Kadlec

With inflation edging to its highest level in 15 years, a lot of investors are discovering Treasury inflation-protected securities, or TIPS. They are government bonds that offer a guaranteed cushion against inflation, and since they were introduced in the late 1990s, investors have sucked up $350 billion worth--equal to nearly 10% of all outstanding Treasury securities. Much of the demand has surfaced in the past two years, as inflation pushed north of 3% (4.1% annual rate in January) and the TIPS program expanded to include five- and 20-year bonds along with the flagship 10-year I-bond.

Britain, Germany and Japan have similar programs, and the world inflation-bond market should reach $1.2 trillion next year, nearly tripling since 2003.

Are TIPS right for you? On the surface, they certainly seem like a sweet deal. Inflation poses the biggest risk to the wealth of anyone investing in government bonds. That's because those bonds pay a fixed interest rate over a long period, and the value of any fixed-income stream erodes as inflation rises. But TIPS come with a twice-a-year adjustment that raises their value at the rate of inflation. You get the yield on top of that. That feature makes TIPS ideal for conservative investors who will hold their bonds to maturity and just want to make sure they stay a step ahead of the inflationary goblin.

TIPS have a low correlation with stocks and all other bonds, meaning they often go up when other things go down. That makes them a great tool for diversifying. Over the past eight years, TIPS have returned 7.8% a year, handily beating both stocks (4.8%) and Treasury bonds (5.9%), reports brokerage Brown Brothers Harriman.

But now pension and foreign money is flooding into TIPS. With too many buyers chasing too few bonds, TIPS carry a paltry after-inflation yield of 2%. "People are going to wake up one day and decide that a 2% real yield just isn't enough," says Joe Shatz, a bond analyst at Merrill Lynch. If that happens, demand will fall, and TIPS holders will take a hit. Shatz advises waiting for an after-inflation yield of 2.5%. Until then, a short-term bond fund or bank CD will do nicely.

Also, TIPS can offer a false sense of security, says Jim Ludwick, a fee-only financial adviser in Odenton, Md. The inflation adjustment is pegged to the Consumer Price Index, which he believes understates true cost-of-living increases. Says Ludwick: "This is a product for people who don't want to risk losing money."

Yet even for risk takers, there are good arguments for playing it safe by putting 5% to 10% of your portfolio in TIPS. If pension money keeps rolling in--TIPS are useful for institutions addressing pension reforms--TIPS may keep right on chugging along.

For tax reasons, TIPS are best held in an IRA or a 401(k). That's because all gains from TIPS are subject to yearly federal income tax, even though a potentially large portion of the gains can't be collected until the bond matures.

It comes down to this: today T-bonds yield 4.6%--2.6 percentage points higher than TIPS' after-inflation yield. So the market is betting that inflation will average 2.6% a year over 10 years. If you want to own bonds and think inflation will be lower, choose T-bonds. Otherwise, take TIPS, and sleep better. [This article contains a table. Please see hardcopy of magazine.] Inflation Beaters BOND FUNDS Return 1-YR. Return 3-YR.* American Century Inflation Adjusted 3.00% 2.62% Fidelity Inflation Protected 2.57% 2.69% Wells Fargo Inflation Protected 2.29% 4.53% T. Rowe Price Inflation Protected 4.51% 4.23% Hartford Inflation Protected 4.19% 3.72%

* Three-year return is annualized. Source: Morningstar