Can TIPS help me beat back inflation?

Treasury Inflation Protected Securities seem logical in today’s market, but make sure you have a diversified, long-term strategy and don’t overload.

Question: Are TIPS a good investment today since we are facing inflation? There seems to be a lot of discussion about them, both pro and con.—Hans, Nashville, Tennessee

Answer: That depends. If by “good investment” you’re asking whether TIPS - or Treasury Inflation Protected Securities - can shield a portion of your assets from inflation then the answer is yes.

After all, that’s what TIPS are designed to do. They pay a fixed coupon rate of interest that’s lower than that of regular Treasury bonds. But the principal, or face value, of TIPS is adjusted to keep pace with changes in the consumer price index. The result is that as the CPI rises, so do the interest payments and the face value of your TIPS, giving you a sure hedge against inflation.

But if by “good investment” you are asking whether you should load up on TIPS in hopes of ratcheting up your returns by capitalizing on investors’ growing inflation fears, then my answer would be no.

Why? Well, for one thing I don’t think it ever makes sense to dramatically overhaul your portfolio to protect yourself from one particular threat or capitalize on one specific opportunity. If you’re wrong you can take a beating. You also run the risk of ending up as one of those investors who spend their time looking for the next big score, but who are more likely sabotaging themselves with lousy timing and onerous transaction fees.

And in the case of TIPS, there’s another reason this isn’t a good time to think of making a killing in them: they appear to be pretty richly priced.

As inflation fears started to pick up late last year, investors began pouring money into TIPS, driving up their prices and lowering their yields. Recently, the “real” yield on 10-year TIPS—that is, the percentage they pay above inflation—was hovering around 1.4%, quite a bit lower than the average of 2% since TIPS were introduced in 2003.

Another way of looking at that yield is to compare it to the recent yield on regular 10-year Treasuries, which, at 4.0%, was 2.6 percentage points higher than that of TIPS. Essentially, this means that for you to do better in TIPS than in regular Treasuries, inflation would have to exceed 2.6% a year for the next 10 years. That’s hardly impossible. But that margin is typically more like 2.3 percentage points, which means that at current prices TIPS already reflect higher inflation expectations than in recent years.

I’d also add that while TIPS are the surest way to hedge against inflation, there are other investments to consider, including REITs and funds that invest in natural resources and commodities.

And let’s not forget—dare I utter the word given the beating they’ve taken this year?—stocks. It’s important to understand the way in which stocks provide protection from inflation. They’re not a hedge in the sense TIPS are. Indeed, if anything, rising inflation expectations tend to drive stock prices down.

Over long run, however, stocks tend to generate the highest inflation-adjusted returns. From 1926 through 2007, for example, large-company stocks beat inflation by roughly seven percentage points annually compared with about 2.3 percentage points for intermediate-term government bonds and less than a percentage point for Treasury bills.

I’m sure I don’t have to mention that those performance stats come with a few big caveats. But I will. Those results aren’t guaranteed, the margin could very well be a lot smaller in the future and stocks can run into some severe setbacks, as they have recently.

For more on how to build a portfolio that provides a decent measure of protection against inflation but also incorporates stocks’ long-term growth potential, I suggest you check out the Inflation: 4 Ways to Protect Your Assets story in Money’s July issue.

If after reading it, you want to add some TIPS to your portfolio, you have two choices. You can buy a mutual fund that specializes in TIPS (and we just happen to have such a fund on our Money 70 list of recommended funds). Or you can buy TIPS directly from Uncle Sam.

If you plan to use TIPS primarily as a diversification tool as opposed to spending the income, I think you’ll find the mutual fund route more convenient and practical. The fund will automatically reinvest the income, plus owning a fund will make it easier for you to rebalance your portfolio. Rebalancing will also assure that you’ll end up with TIPS at a variety of prices, as you buy or sell shares over the years to maintain the target percentage of your portfolio in TIPS.

One final note. You’ll be taxed on the inflation adjustment to your TIPS’ principal even though you don’t reap that gain until the TIPS mature or you sell them. So to avoid having to fork over taxes on those gains, you’re better off holding TIPS in tax-advantaged accounts like a 401(k) or IRA.