Markets & Stocks
    SAVE   |   EMAIL   |   PRINT   |   RSS  
Kick inflation with TIPs
Unique inflation-protected securities can serve to reduce inflation risks and diversify portfolios.
October 25, 2005: 4:31 PM EDT
By Rob Kelley, CNN/Money staff writer

NEW YORK (CNN/Money) - Inflation is back -- or at least worrying about it is.

As inflation numbers hit long-time highs over the past two weeks, investors looked with renewed interest at a unique class of bonds that preserves returns -- inflation-protected securities.

Regular bonds have a stated yield, but a inflation effectively lowers "real" returns over the bond's lifetime.

Inflation-protected securities (IPSs) pay their interest in two parts. The first is based on the inflation rate, so if prices rise 2 percent, the investor is guaranteed that 2 percent. Then the bond pays a modest return on top of that.

But IPSs don't necessarily jump during periods of soaring prices -- their attractiveness depends on how well normal bonds perform.

If normal bonds are yielding 6 percent, and an IPS is offering a 3 percent yield, then inflation must be above 3 percent to make the IPS worthwhile. This is known as the break-even inflation rate.

"Inflation-index bonds aren't a home run in an inflationary environment -- they're just not as bad as everything else," said John Brynjolfsson, Portfolio Manager at Pimco Real Return Products. "And nominal bonds are still the ones that profit the most in a low-inflation environment."

If inflation is low -- as in the past several years -- IPS' relative performance will suffer.

In September, the Consumer Price Index (CPI), saw its largest monthly gain in 25 years (full story) and is now up 4.7 percent on the year.

"I think inflation can be an overlooked risk in conventional bonds," said Bill Irving, Portfolio Manager for Fixed Income funds at Fidelity. "The rate of inflation has been higher than the yield of the 10-year Treasury bond over the past few years. TIPS are indexed to the CPI, so they avoid that downside."

The US Treasury issues inflation-protected securities (TIPS) in different maturities, the most common of which is the 10-year TIPS bond.

TIPS are currently available in terms of 5, 10, and 20 years, and are sold in increments of $1,000. They pay interest twice a year.

At the last auction of 10-year Treasury bonds, they were issued with an interest rate of 4.25 percent. 10-year TIPS last were issued at 1.875 percent plus the inflation rate. So inflation would have to remain above 2.375 -- the break-even point -- for TIPS to have higher returns than Treasuries.

How TIPS fit in

TIPS are also unique because their returns are not closely tied to those of stocks and traditional bonds. "If you look at returns, TIPS have a very low correlation to other assets classes," said Irving.

Because they can withstand inflation that might pummel bonds and stocks, TIPS are a growing part of a balanced portfolio for investors.

"The important advice to an investor is that TIPS are a diversifier -- they should be used as a portion of your fixed-income investments," said Volpert. "Investors shouldn't chase performance by trying to time the market."

Investors can purchase TIPS directly from the US Treasury -- with no broker involved -- by opening a TreasuryDirect account. Or they can invest in the many inflation-protected bond products available from brokerages like Fidelity, Pimco and Vanguard.

Analysts involved in TIPS-based funds recommend a mix of fixed-income investments. Putting 25 to 30 percent of your fixed-income investments in TIPs vehicles and the remainder in normal bonds can potentially lower an investor's risk and raise returns compared to a portfolio of just bonds.

"It's a good place for investors to put their 'grocery money' -- money you can't afford risking," said Brynjolfsson. "TIPs are a very secure investment."

Inflation ahead?

Despite the recent gains, inflation could be kept tightly contained based on the Fed's recent determination to continue its interest rate hikes in the wake of Hurricane Katrina's effects. The new nominee for Federal Reserve Chairman, Ben Bernanke, has a track record of low tolerance for inflation. (Full story)

"The inflationary spiral that could happen with energy prices is too potentially dangerous," said Ken Volpert, Senior Portfolio Manager at Vanguard. "The Fed would rather overreact than see anything similar to past inflation problems."

Katrina and the disruptions in energy markets are short-term inflationary concerns, but analysts believe the long-term looks much better.

"Global labor markets will result in continued downward pressure on labor, inflation, and service, and that will keep the overall inflation rate under control," said Pimco's Brynjolfsson.

So while it's certainly not the time to stake it all on TIPs, a healthy balance of the inflation-protected bonds can give investors added peace of mind -- and healthy returns -- in periods of market volatility.


For an upcoming feature, MONEY magazine would like to profile a stay-at-home mom trying to re-enter the workforce (or someone who has recently made the transition). To be considered, e-mail your story to Kate Ashford at


Do as they do, not as they say: Wall Street pros' investing habits analyzed -- click here.

For the latest in Personal Finance headlines, click here.  Top of page

Follow the news that matters to you. Create your own alert to be notified on topics you're interested in.

Or, visit Popular Alerts for suggestions.
Manage alerts | What is this?