TIPS You Can Trust

Although the U.S. hasn't seen much inflation as a result of the Fed's quantitative easing, investors want to be prepared for whenever it does occur. Here's one investing vehicle that by their very definition protect against inflation.

Most everyone agrees that interest rates will go up; not everyone is in consensus about when. Whatever the case about the timing, many are trying to get prepared.

One way to do that is to invest in Treasury Inflation Protected Securities (TIPS). By their very definition, TIPS protect against inflation. Though the way they work is complicated, the bottom line is this:

During inflationary periods, interest on TIPS goes up

During deflationary periods, interest on TIPS goes down

Since interest and principal are inverse, if the interest is up, the bond price is down and vice-versa. However, at maturity the bond will yield 100 cents on the dollar. This makes TIPS a relatively safe investment.

Though it is possible to buy an individual TIPS from the federal government through Treasury Direct, most investors prefer the ease of a fund. There are some factors to consider in making a fund selection.

For those who think inflation will surface sooner rather than later (in spite of what Mr. Bernanke says), short-term TIPS are a better choice than longer term ones. This is because short-term TIPS are less affected by inflation. If, on the other hand, someone believes inflation will be later rather than sooner, intermediate-term TIPS are a better choice. Since very few investors are choosing long-term TIPS because of their potential volatility with inflation, they won’t be included here.

Once the term is chosen, the fund itself has to be selected. There are a lot out there and below is only a selection of the possibilities. There are TIPS that are mutual funds as well as exchange traded funds (ETFs). How they differ has been addressed previously on Physician’s Money Digest. Mutual funds are represented by five letter symbols, ETFs by three or four. The below are all ETFs.

Company

Ticker Symbol

Term

Index

Expense Ratio (%)

Schwab

SCHP

Short

Barclays U.S. TIPS Index (Series L) SM

0.07

Barclays

STIP

Short

Barclays Capital U.S. TIPS 0-5 Years Index (Series-L)

0.20

Vanguard

VTIP

Short

Barclays Capital U.S. TIPS 0-5 Years Index (Series-L)

0.10

PIMCO

TIPZ

Inter

Bank of America Merrill Lynch US Inflation-Linked Treasury Index

0.20

Lehman

TIP

Inter

Barclays U.S. TIPS Index (Series-L)

0.20

Barclays

IPE

Inter

Barclays U.S. TIPS Index (Series-L)

0.18

Risk

Though TIPS are safe compared to most investments, they are not without risk. Firstly, if they are long term they could be volatile. As interest rates move up, the underlying price of the TIPS bond moves down. The bond could lose value though the cost basis would be recovered at maturity.

Secondly, if there were a prolonged period of deflation, interest would be less, though the bond price would move up to compensate until maturity when the original cost of the bond would be paid dollar for dollar. Still, the total return would be less than anticipated under inflationary conditions. Buying shorter term bonds could help compensate for this.

Lastly, the TIPS adjustment is based on the Consumer Price Index (CPI) that is non-seasonally adjusted. If a family has expenses that outstrip this figure, TIPS may not be as optimal for them as another family that is in sync with the CPI. For example, those with children in college — the cost of which has outstripped the CPI — may not want to rely on TIPS to support them to the same degree as families that do not have children in college.

Read more:

Smart Investing in Tax-Advantaged Accounts

Treasury Inflation Protected Securities (TIPS) are typically recommended because they pay dividends that are taxed and the dividend may increase in the future in the event of inflation.

Reach Your Retirement Requirement

Jane and Bob’s $1 million so-called riskless portfolio might include Treasury Inflation Protected Bonds, among several other possibilities. This is the portion of the portfolio meant to cover living expenses (along with Social Security and pension payments). They are theoretically risk free since they are backed by the federal government. Because they pay dividends that are taxed, they are typically recommended for the tax-advantaged part of a portfolio.