TIPS for inflation protection

Treasury Inflation-Protected Securities, or TIPS, have been battling inflation in portfolios since 1997. You can buy this protection in the form of an individual bond, an exchange-traded fund or a mutual fund.

The Treasury Department uses the Consumer Price Index, or CPI, as a guide to adjust the principal for inflation on a semiannual basis. A fixed interest rate is paid semiannually on the adjusted principal.

For example, if you buy a $10,000 bond with an interest rate of 2 percent but inflation equals 3 percent that year, the face value of the bond will be increased by $300 to $10,300 and the 2 percent interest rate will be applied to the new face value. So, what happens if you own the bond in a deflationary environment? The principal will be adjusted downward, but as long as you hold until maturity you'll receive your original investment.

TIPS bonds are meant to be long-term investments. There is a secondary market, meaning you can sell your bond before maturity, but as mentioned, you won't receive your full principal investment if you've owned the bond during a deflationary period.

Individual bonds

Newly issued TIPS bonds are bought at Treasury auctions through the government Web site or through a broker. The bond's yield is determined at auction. Some brokers don't charge a fee for Treasury auction orders placed online, but do charge if you need the services of a representative. There is no fee when buying through TreasuryDirect.

TIPS are issued in maturities of five, 10 and 20 years. They are auctioned during specific months according to their maturity. Five-year TIPS are auctioned in April and October; 10-year TIPS in January, April, July and October; and the 20-year in January and July.

There are two ways to participate in the auctions. By far, most individuals place a noncompetitive bid. As such, you agree to the yield determined at auction. You can also place a competitive bid where you state the yield you're willing to accept. If you go the noncompetitive route, you'll likely get a better rate because you're essentially going along for the ride with the money managers who can demand a better rate because they're spending millions at the auction.

If you prefer to place a competitive bid, you'll have to do it through a broker because TreasuryDirect doesn't accept competitive bids from individuals.

Not long ago, the minimum purchase price for a TIPS bond was $1,000, with additional purchases in increments of $1,000. But that rule has been changed and you can now buy a TIPS bond for as little as $100, with additional purchases in increments of $100. The limit for a single auction with a noncompetitive bid is $5 million.

Interest and principal growth in TIPS are subject to federal tax, but exempt from state and local taxes. While tax on interest may be deferred until the bond is redeemed, tax on any principal increase is due the year in which it's gained even though you don't receive the inflation-adjusted principal until the bond matures. If possible, hold TIPS in a tax-deferred account or, better yet, a Roth IRA.

TIPS are sold only in electronic form.

Also consider the government's inflation-fighting savings bond, the I bond, when looking for fixed-rate inflation protection.

Exchange-traded funds and mutual funds

If a long-term commitment to a bond isn't right for you but you'd still like to tap into some inflation protection, exchange-traded funds or mutual funds are options.

A major difference between a bond and an ETF or a mutual fund is that the bond comes with a guarantee that you will receive your full principal if you hold the bond until maturity. While the underlying bonds in an ETF or mutual fund have maturity dates, the fund itself does not. What you get depends on when you sell your shares.

Bankrate isn't in the business of recommending specific stocks, ETFs or mutual funds, but some of the more popular anti-inflation ETFs are iShares Lehman TIPS Bond (TIP), SPDR Barclays Capital TIPS (IPE) and SPDR DB International Government Inflation-Protected Bond (WIP).

TIP and IPE hold U.S. Treasury inflation-protected bonds while WIP focuses on inflation-fighting bonds issued by foreign governments.

There are scores of mutual funds that offer inflation protection. Again, here are a few widely popular funds to consider researching: Vanguard Inflation-Protected Securities (VIPSX), Fidelity Inflation-Protected Bond Fund (FINPX), T. Rowe Price Inflation-Protected Bond Fund (PRIPX), and Schwab Inflation-Protected Fund (SWRSX).

Not all inflation-protected funds invest solely in government inflation bonds. Some may invest a small portion of the portfolio in corporate bonds in an effort to boost returns. Be sure to explore all of the details before buying.

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