investing

Are you betting on TIPS and inflation?

Business woman holding money.
Highlights
  • The Fed plans to keep inflation at just 2 percent per year.
  • Low yields on CDs and other investments are hammering savers.
  • TIPS may not be the inflation cure-all that investors think they are.

Low yields on Treasuries, even for Treasury inflation-protected securities, or TIPS, aren't fading anytime soon.

In September, the Federal Reserve extended the period during which it will keep short-term interest rates near zero percent through mid-2015 to spur economic growth. The Fed also plans to keep inflation, which feeds higher interest rates, at just 2 percent per year.

These pledges should be easy to keep, says Robert Barone, economist and portfolio manager at Reno, Nev.-based Universal Value Advisors. The U.S. is in a deflationary time because the economy is struggling. Consumer prices are mostly falling -- the opposite of inflation, he says.

The result is that bond prices are at historic lows, and it's improbable that interest rates will rise, with inflation a long way off from returning, Barone says. With that backdrop, here is what it will mean for one type of investment -- Treasury inflation-protected securities.

TIPS and inflation

As their name says, TIPS are meant to act as a counterweight to inflation. You can buy them directly at auctions or through mutual funds.

These are bonds backed by the U.S. government that are pegged to a key inflation barometer -- the U.S. Consumer Price Index. It measures the cost of a basket of goods and services.

As the index falls or rises, so does the face value, or principal, of TIPS. TIPS also pay a fixed rate of interest, or coupon rate, every six months. When inflation rises, TIPS gain in value as their principal readjusts upward.

Even if inflation does heat up, TIPS are currently overvalued, says Marilyn Cohen, co-author of "Surviving the Bond Bear Market: Bondland's Nuclear Winter." "People have been pouring money into them," she says.

There's a reason they may be overvalued. These days, the Treasury Department is auctioning TIPS at negative yields. For example, five-year TIPS maturing in 2017 were sold recently at such yields. A negative yield occurs when the TIPS "real" yield -- the coupon rate minus the current annual rate of inflation -- is below zero. Without inflation, the investor will receive a smaller amount paid out than was originally invested.

That's a good reason to avoid TIPS at shorter maturities, Cohen says: "You won't make any money."

TIPS may not be the inflation cure-all that investors think they are anyway. "They're not good inflation hedges," says David Houle, portfolio manager at Colorado-based Season Investments. "People think that you'll get a positive return on TIPS if inflation heats up."

In fact, the inflation component only adds a small return, he says. If held to maturity, TIPS holders receive the face value of the bond plus interest, even if inflation doesn't rise.

"Huge spikes in inflation could help you make good money, but usually buying a TIP and holding it for 10 years only translates into returns similar to regular Treasuries," Houle says. The result is a small yield that may equal that of a traditional Treasury bond. And deflation, the opposite of inflation, can dampen returns even more.

Cohen says selling TIPS before they mature also could land you in negative territory even if interest rates do rise. Why? Despite their inflation kicker, TIPS are still essentially Treasury bonds. So, as interest rates rise, prices may fall.

That's why stocks and real estate are the ultimate hedges over time, says Rick Ashburn, a chief investment officer at Creekside Partners in Lafayette, Calif. "When buying TIPS, you must first accept negative real yields, and that's not all. TIPS gains and yields are taxed every year, even though payouts are at maturity," he says.

On the upside, TIPS suit investors hungering for some liquidity, says Greg McBride, CFA, senior financial analyst at Bankrate.com. "(But) at best, you're lucky to preserve your buying power," McBride says.

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