TIPS May Provide Some Protection Against Inflation

Federal Reserve Chairman Ben Bernanke says prices may be going up right now, but he believes inflation isn't a threat for the future.

But suppose you aren't so sure and want some protection. You could buy gold and silver as a hedge, but prices of both metals have been falling this week from their record highs. That might be a bit risky until they find a bottom.

Another option is Treasury Inflation-Protected Securities, otherwise known as TIPS. Many financial advisors see these government-issued bonds as a fairly safe inflation hedge, though like any security, they aren't without some risk.

Protect purchasing power

"TIPS can help protect your purchasing power over time, because principal and interest payments are adjusted to reflect changes in the price for U.S. goods and services," said John W. Hollyer, who co-manages the Vanguard Inflation-Protected Securities Fund.

Here's how TIPS work: the government regularly adjusts the principal, affecting the dollar amount of interest paid, based on the actual inflation rate during life of the bond. The principal can drop if consumer prices drop, but the investor is guaranteed to receive at least face value when the bond matures.

So, if there is deflation instead of inflation, the face value of your investment can go down. But if the Consumer Price Index goes up, so does the face value of the investment.

Other bonds

With a regular bond, your investment earns a set interest rate. The marketable value of the bond can go up or down, depending on the movement of interest rates, which influences the market for your bonds.

For example, if you have $1000 in bonds paying a three percent yield, the bonds might be worth more than $1000 if the prevailing rate paid by new bonds fell to two percent. An investor might pay a small premium for your bonds to receive they extra one percent in yield.

On the other hand, your investment could be worth less than $1000 if the yield on new bonds rose to four percent. Investors would not be willing to pay you the face value of your bonds earning three percent when they could invest the same money and get four percent.

As with any investment, TIPS investors must remain alert and respond to market conditions. If growth picks up and higher inflation follows, the Fed might tighten monetary policy, leading to rising real interest rates. This could result in low, or even negative, total returns for TIPS in the short term, although they still could outperform conventional Treasuries.

"There is no magic with TIPS," Hollyer cautioned. "Don't think that inflation adjustments mean TIPS prices won't fall."

Inflation outlook

Before investing in TIPS, an investor needs to think there is a realistic chance of inflation. Two weeks ago the conventional wisdom held that inflation was building in the economy. In the last few days, however, that belief appears less certain.

Gold and silver prices are falling. So is the price of oil, though gas prices – closing in on a national average $4 a gallon – have yet to follow suit. Industrial metals, which had enjoyed a significant run-up, along with precious metals, have pulled back sharply. Mortgage rates continue to fall while the battered greenback is beginning to rebound.

Could it be that the markets are worried about the economy? Maybe, especially if traders remember 2008. Gasoline and food prices rose sharply in the first half of that year, only to be followed by a recession. And a Great one at that.