TIPS -- Enough return for your money?
By Laura Bruce • Bankrate.com

When inflation is akin to a hummingbird on an elephant's back, your nest egg is safe from erosion. But when prices spiral upward, your savings need protection to make sure the $10,000 you sock away buys you $10,000 worth of vacation, education, pickup truck or whatever when you're ready to spend the money.

One way to ensure that is to buy an inflation-protected investment such as Treasury Inflation-Protected Securities or TIPS.

The U.S. Treasury currently issues only 10-year TIPS. A five-year and a 30-year version have been discontinued, although you can still buy 30-year TIPS on the secondary market. The Treasury is considering issuing 20-year TIPS, and possibly reviving the five-year or some term shorter than the 10-year.

The Treasury calls TIPS the "safest of the safest" investments. That's because you can't lose your initial investment. TIPS are pegged to the Consumer Price Index and the principal is periodically adjusted to increases, or decreases, in the CPI. Semi-annual fixed-interest payments are based on the updated principal.

If you have the misfortune of holding TIPS during a lengthy period of deflation, the Treasury guarantees that you'll still receive your initial investment at maturity.

"TIPS are an excellent investment," says Tom Grzymala, founder and principal of Alexandria Financial Associates in Alexandria, Va.

"TIPS have proven, historically, less volatile than Treasuries, plus there's less price depreciation than with Treasuries. Treasury bond prices go down when interest rates go up. Why raise interest rates? The threat of inflation. TIPS protect you against that. The benefit in purchasing power is sensational."

But Grzymala cautions that it's not as simple as saying investors should buy TIPS if they expect an increase in inflation. You don't want to overpay for TIPS just to get the inflation protection.

Because TIPS have the benefit of inflation protection, they pay less interest than a comparable security that lacks the inflation protection component. Daniel Shackelford, senior portfolio manager of the T. Rowe Price Inflation Protected Bond Fund, says investors should check comparable maturities.

"The starting point is to look at the 10-year TIPS. Let's say it's offering a 1.8 percent coupon versus the fixed-rate 10-year Treasury note which, for the sake of this example is offering 4.1 percent. Those 230 basis points need to be made up somewhere. The rate of inflation needs to be at that rate or higher. If inflation is at 1.9 percent, that leaves 40 basis points that need to be made up at some point over time.

"You could argue that 40 basis points isn't too much of a premium to pay for protection in case inflation goes to 2.4 percent or higher and wreaks havoc on the real value of some of your assets," Shackelford says.

Not everyone is enamored of TIPS.