Have No Fear

TIPS offer a way to hedge against inflation

p_30Perhaps you’ve noticed recently that the investment landscape has been long on turbulence and short on stability. It’s in times like these that investors often seek out shelter in sound, conservative investments such as TIPS, or Treasury Inflation-Protected Securities. The principal on these U.S. government bonds increases with inflation and decreases with deflation, as measured by the Consumer Price Index.

Peace of mind has been a luxury of late. We all know what happened to stocks in 2008. And while the equity market staged a rally early in 2009, many pundits say the upswing could be short-lived. Meanwhile, the Federal Reserve, has slashed interest rates in the name of buoying the economy––a move that has brought bond yields down to miniscule levels. And if that isn’t enough, many experts now believe the Obama administration’s efforts to save the economy could bring about a period of high inflation.

At first blush, TIPS seem to hold many answers.  As a bond, they offer stability––the promise to provide investors with steady amounts of income twice a year and return their principal after a specified period of time. What’s more, TIPS are issued by the Treasury Department and backed by the U.S. government, a debtor that despite recent deficit spending still enjoys a good reputation in the investment community.

TIPS aren’t the only inflation-fighting bond offered up by the Treasury.  I-Bonds, another offering, are pegged to the CPI as well, but offer investors less flexibility. TIPS are adjusted to CPI fluctuations monthly, whereas I-bonds are tweaked twice a year in May and November. TIPS can be bought and sold through a broker at any time; I-bonds must be redeemed and cannot be traded. I-bond holders pay a penalty if they opt out within the first five years.

Investing in TIPS is fairly straightforward. They come in five, 10, and 20 year maturities––that is, the number of years investors receive interest payments before their principal is returned. Investors can purchase TIPS directly from the government in $100 denominations at www.treasurydirect.com. Nonetheless, there are a couple of important caveats. One consideration is that TIPS income payments are taxed as income by the government, an assessment that can take a sizable chunk out of the bonds’ return.  As a result, financial advisers say a TIPS investment works best in a tax-deferred IRA or 401(k) account. Another factor to keep in mind is that during deflationary periods, a TIPS’ underlying value decreases in line with the CPI.  Lawrence Jones, an analyst with the Chicago investment research company Morningstar, says investors “don’t have to bet the house,” on TIPS. A 5% to 10% allocation in a personal portfolio makes sense.

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