Time to Add More TIPS to Your Portfolio?

by Linda Stern / Reuters

With U.S. gasoline selling under $2 a gallon, food prices relatively flat and Wall Street bond traders betting on 1.5% annual inflation as far the eye can see, it may seem like the wrong time to worry about rising consumer prices.

But some voices - including a few at the policy-setting Federal Reserve - are suggesting consumer inflation could take off faster than expected.

If oil reverses its recent steep decline and wages begin to move up in response to a tighter labor market, inflation could once again become a factor for investors to reckon with.

Some investors already are preparing for that reckoning.

Some big financial firms, including BlackRock, are telling their clients to hedge against inflation by buying funds that hold Treasury Inflation-Protected Securities, or TIPS.

These bonds, along with consumer-facing I-Bonds, peg some of their interest to the Consumer Price Index (CPI). So as inflation speeds up, holders of those bonds earn enough interest to keep up with it.

Investors have poured $2 billion in new money to TIPS exchange traded funds in the last 16 weeks. That may be an obvious bet: currently, 10-year TIPS are priced, relative to plain vanilla Treasuries, in a way that would reward investors should CPI inflation over the next 10 years top 1.57%. The Federal Reserve is targeting 2% inflation over next two years.

That makes TIPS seem like a slam dunk. With New York oil futures trading at around $38 per barrel, it is hard to imagine a world where U.S. consumer prices will not rise by more than 1.57%.

But think twice before you jump in with both feet - and your retirement account. The following are some of the downside risks you take when you bet on inflation with TIPS:

* Protection is limited. TIPS funds may jump quickly in value if investor sentiment starts to reflect big inflation expectations, but they rarely reward investors over time for sustained inflation. At best, they merely pace the CPI with a lag, so you can protect the amount of money you have in a TIPS fund from the effects of a rising CPI. They are not going to overcompensate. To hedge against a big and sustained pickup in prices, you are better off investing in stocks of companies that really jump during times of inflation, such as energy and real estate. Since 1970, the stock market sectors that have performed best during months of rising consumer prices are energy, information technology, materials and healthcare, according to Sam Stovall of S&P Global Market Intelligence.

* There is a worst-case scenario. Like all other bonds, i-bonds lose value when interest rates go up. Should interest rates rise faster than inflation does - expanding what economists call "real rates" - holders of TIPS may get slammed. And because their bonds currently are lower-yielding than Treasuries of comparable maturities, they will become less valuable as rates rise, and not be cushioned by any rising-CPI payouts.

* You have to plan around a tax hit. Even if you hold your TIPS and TIPS funds for years and years, you will be liable for federal income taxes on the income you earn every year, including the increase in value of the bond should rates fall. That means that if you decide to invest in them, you should do so from within a tax-favored account, such as an individual retirement account or 401k.

* You might be betting wrong. Though TIPS currently are favorably priced, it will take a global economic surge and a recovery in oil prices before there is any big jump in inflation, according to Dan Shackelford, portfolio manager of the T. Rowe Price Inflation Protected Bond Fund. "I don't think we're in the midst of a forced march to higher inflation anytime soon," he said.