Inflation Protected Treasury Bonds (TIPS) Are Interesting

Inflation-protected bonds (TIPS) are looking interesting these days. TIPS are bonds issued by the US Government that guaranty you a fixed return (usually around 2%) PLUS whatever inflation (CPI) turns out to be each year. These bonds are one of the safest investments you can make because there is very little or no credit risk (issued by the US government), liquidity risk (TIPS are heavily traded), or inflation risk. These TIPS bonds adjust their principal value and payout twice a year to compensate for any inflation.

Hedge Against Rising Inflation
PIMCO's Bill Gross, one of the most successful bond managers in decades, recommended inflation-protected bonds in early January 2009. "TIPS will benefit if and when the government's efforts to reflate (the economy) begin to take hold." These efforts to reignite the global economy will lead to faster inflation than is currently priced into the securities. Historically when the government has stomped on the monetary gas pedal to get the economy going by flooding the market with liquidity it has led to increased future inflation. TIPS bonds allow you to be hedged against the risk of rising future inflation. Inflation is one of the primary risks to a financially secure retirement. In my opinion TIPS inflation protected bonds are now extremely attractive relative to regular US treasury bonds which are in a "bubble" right now and will suffer if/when inflation concerns increase again. The "yield spread" between TIPS bonds and regular treasury bonds is now about the most extreme it has ever been (in favor of TIPS being more attractive).

Hedge Against Deflation
Right now investors are more concerned about deflation (due to the very weak economy) than inflation, which is why these inflation-protected TIPS bonds are priced much more attractively than normal. TIPS are attractively priced now precisely because inflation expectations are low. You don't want to buy flood insurance after the water is already in your home. By then, it is too late and the price of protection is too expensive. Many investors are unaware that these TIPS bonds are also a hedge against deflation because at expiration you get the accumulated principal value of the inflation adjustments or par value, whichever is greater. If there is massive deflation for years your "real" return after inflation/deflation would be very good because you would get the par value of the bonds at expiration. Maybe they should call these "Deflation-Protected Treasury Bonds"? The outlook for the economy is very uncertain right now. Will it rebound in the second half of 2009 resulting in rising inflation or will it continue to spiral downward causing deflation? It seems to me that TIPS could be pretty solid investments in either scenario. That is not true for most other investments.

Great Portfolio Diversification Benefits
Another reason to consider adding inflation-protected treasury bonds (TIPS) to your portfolio is the powerful portfolio diversification benefits they bring. This reduces the overall risk and/or volatility of your portfolio over time. The returns on TIPS bonds have low or negative correlation with the returns of many other traditional investments such as stocks and regular bonds. The correlation of TIPS returns with the overall stock market (SP500 index) over the past years has been only 34%. Over longer periods of time the correlation of TIPS bond returns with the stock market and with traditional bonds has been close to zero. Rising inflation expectations are good for TIPS returns but in the short term are negative for the returns of stocks and bonds and vice versa.

Best Ways to Invest in TIPS
I am a fan of exchange-traded funds (ETF's) due to their very low costs and superior tax efficiency (and other reasons). The most liquid exchange-traded fund that invests in inflation-protected treasury bonds is the I-Shares (Barclays) fund with the symbol "TIP". The expense ratio on this ETF fund is only .20%. The trailing 12-month yield on this ETF fund has been 6.46% (including the inflation adjustments). The Vanguard Inflation-Protected Securities (VIPSX) is a good low-cost index mutual fund (also a .20% expense ratio). As with all bond funds that pay out interest income, these funds are not very tax-efficient so they are better off held in a tax-deferred account (401K or IRA) if possible. The yield on these TIPS funds is currently about 2.5% (plus whatever inflation is going forward). You can also buy these TIPS bonds directly from the US treasury online.

Keith Tufte
President
Longview Wealth Management, LLC.
http://www.longviewwealth.com