NEW YORK (CNNMoney) -- I'm thinking of stashing cash for emergencies into a Treasury Inflation Protected Securities (TIPS) mutual fund rather than CDs or a money-market account. The return is better and the risk doesn't seem to be much higher. What do you think of this plan? -- Ronnie Colvin, Madison, Alabama
With short-term interest rates barely positive, I understand why you're anxious to earn more on your cash.
But the move you're considering can be dangerous, as many investors have discovered after they've snapped up everything from annuities and bank loan funds to auction-rate preferred securities and non-bank CDs in search of higher returns.
Recently, some people have toyed with the idea of switching out of low-yielding bonds and into dividend-paying stocks to grab extra yield. The problem is that the potentially higher yield, or returns, inevitably comes with more risk -- even if the risk isn't readily apparent.
And that's true for TIPS as well.
TIPS pay a real, or inflation-adjusted, yield. Between 2003 and 2011, the real yield for 10-year TIPS averaged 1.7%. If you bought TIPS at that average return and held until maturity, you would be assured of getting a return of 1.7 percentage points a year above the inflation rate over the term of the bond.
But like the yield on regular bonds, the real yield on TIPS also goes up and down based on how much investors are willing to pay. Due to buying by individuals, institutional investors and the Federal Reserve over the past year, so much money has flowed into TIPS that their real yields have been driven down into negative territory (although a negative TIPS yield doesn't necessarily translate to a negative return, as inflation adjustments could ultimately push the return back into positive ground.)
Since bond prices and bond yields have a seesaw relationship -- when one rises, the other falls and vice versa -- the decline in real yields has worked to the advantage of people who bought TIPS at earlier, higher yields. Over the past year, Morningstar's inflation-protected bonds category has gained an impressive 14%.
Based on returns like that, it's easy to assume TIPS are a safe harbor offering inflation protection and lofty returns.
But real yields can go up as well as down. And if they do -- which many people consider likely given how low they've sunk -- the market value of TIPS will take a hit. Over a two-week period last August, for example, the real yield on 10-year TIPS climbed from -0.13% to 0.25%. During that period, the value of the iShares Barclays TIPS fund fell nearly 4%.
TIPS with shorter maturities would likely hold their value better. The iShares Barclays 0-5 year TIPS fund dropped by about half as much, or 2.1%, in August.
But the point is the market value of TIPS can go up and down. And since their value can fluctuate, they can't provide the principal protection you want for cash that you may need to tap in the short-term. Indeed, Gemma Wright-Casparius, co-manager of Vanguard's Inflation-Protected Securities Fund, told me investors should expect higher-than-normal volatility from TIPS because their yields are so low. (All else equal, lower bond yields make for wider possible fluctuations in bond prices.)
That's not to say TIPS can't play a role as a long-term inflation-hedge within a diversified portfolio of stocks and bonds that's rebalanced on a regular basis. Granted, TIPS' inflation protection looks expensive at today's depressed real yields. But the return you earn ultimately depends on the future path of inflation. So if inflation goes high enough, you could still end up doing better than in a regular Treasury bond.
But whether you feel they're a good buy for the long-term or not, TIPS are definitely not substitutes for the cash portion of your portfolio.
So by all means shop around for savings accounts, money funds and CDs that pay the highest yields in this low-yield environment.
But for the money you absolutely, positively need on a moment's notice, stick to secure options like FDIC-insured savings or money-market accounts, short-term CDs or money-market funds. (And in the case of money funds, you'll also want to keep an eye on the Securities and Exchange Commission's reform proposals, which could affect the funds' yields and liquidity.)
Bottom line: Scrap any plans for moving your cash reserves into TIPS.
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