TIPS investing offers inflation protection

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Treasury Inflation-Protected Securities, known as TIPS, have enjoyed surging popularity over the last few years, and the number of mutual funds dedicated to these inflation-indexed bonds is on the rise.

TIPS, designed to help investors protect their assets against inflation, aren't the bargain they were a few years ago. But experts say as long as you are comfortable with some short-term volatility, they deserve a spot in your portfolio, perhaps as much as 25 percent of your bond stake.

"Historically, people looked to stocks, real estate, timberland, and those types of assets as a way to hedge against the ravages of inflation," said Wan-Chong Kung, senior fixed-income portfolio manager with Minneapolis-based First American Funds. "TIPS have provided a way for investors -- particularly those who have a view on inflation or who are particularly sensitive or concerned about protecting their income stream -- to directly hedge their portfolios against inflation."

The U.S. government introduced TIPS in 1997, but while many on Wall Street viewed them as a great investing tool, TIPS didn't immediately capture the market's fancy because their returns didn't appear significant at the time, said Eric Jacobson, senior analyst at fund tracker Morningstar Inc. It wasn't until interest rates and bond yields started falling in the past few years that investors began to recognize the value of TIPS.

"There really isn't anything like it in the investing universe," Mr. Jacobson said. "They make great sense as part of a longer-term asset allocation, both for those in the middle portion of their savings years, all the way to retirement. They have a level of predictability with regard to inflation that very few other assets can offer."

When you buy a typical U.S. Treasury, you are loaning a certain amount of money to the government, and in exchange you receive interest payments, and your original investment is returned when the bond matures. The interest payments, hopefully, will make up for any purchasing power lost to inflation during the bond's term, plus offer some "real return" to compensate you for tying up your money with Uncle Sam.

What TIPS bonds do is promise to compensate the investor for the true effects of inflation, after the fact. They do this by changing their values based on the Consumer Price Index -- the government's key inflation reading -- every six months. So if the CPI rises 5 percent, the price of a $1,000 TIPS bond would rise to $1,050. Investors also get interest payments above and beyond inflation, though these are much smaller than the yields on conventional Treasuries. Still, there's a bonus: Because they're a percentage of the bond's underlying value, which goes up with inflation, the coupon payments can also rise.

"The implication is, if inflation turns out to be higher, you will have been better off purchasing the TIPS bond," Mr. Jacobson said. "Think of it like this: You're buying some insurance against inflation being higher than the market thinks it will be."

As they have become more popular, the yields on TIPS have declined while their prices have risen. And fund companies, eager to capitalize on the surge in demand and resulting inflows of cash, started rolling out more TIPS offerings; there are now nearly two dozen inflation-protected mutual funds.

Bargain hunters will gravitate toward the Vanguard Inflation-Protected Securities fund (VIPSX), which has a rock-bottom 0.18 percent expense ratio, making it the cheapest choice among open-ended funds. Another standout is the Fidelity Inflation-Protected Bond fund (FINPX), which recently cut its fees to 0.65 percent. Both offerings have experienced managers who have amassed good track records without taking on a great deal of risk. Also noteworthy is PIMCO's Real Return TIPS fund (IRRAX), which takes a more aggressive approach, though do-it-yourselfers will be put off by the prospect of paying a front-end load to own it.

There's also an exchange-traded fund, the IShares Lehman TIPS Bond fund, (TIP), but with an expense ratio of 0.20 percent, it's more costly than the Vanguard fund. And as always with ETFs, trading costs can be prohibitive for anyone using a dollar-cost-averaging strategy -- meaning you add to your investment on a regular basis.

Before you run out to buy a specialty offering, check your existing holdings to see if you've already got adequate exposure; an increasing number of bond managers have recognized the utility of TIPS, and incorporated them into their portfolios. If you have a smaller bond portfolio, a TIPS fund might not be appropriate for you. Likewise, if you are a relatively young and aggressive investor, you might not need protection from inflation just yet. But TIPS can offer big benefits to investors who don't fall into those categories.

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