Time to buy inflation protection?

Many experts say a little inflation could goose the economy. Consumers would get stuck with slightly higher prices, but that helps businesses expand and puts people back to work. With inflation being so low for so long, and the economy starting to shake off its recession-induced hangover, we may see some meaningful inflation slink back into view before long.

On the other hand, inflation is not a good thing for investments, which may be why inflation-protected investments are being hyped.

Stash $1,000 in a five-year certificate of deposit and you'll get interest, but inflation will eat away at your return. In its simplest terms, if you're earning 3 percent on the CD and inflation is at 2 percent, your real return on the interest is 1 percent.

Inflation-protected investments can help your fixed income keep up with inflation.

Treasury Inflation Protected Securities are one of the best-known inflation fighters. Some financially savvy people are loading up on them. Bill Gross, manager of Pimco Total Return bond fund, the largest bond fund in the country, wrote extensively about TIPS in a recent "Investment Outlook" newsletter.

"If the government is bound and determined to reflate the economy and inflate bondholders down the river, then something with 'inflation protection' in its name seems a reasonable bet. TIPS are one of the few fixed-income sectors that actually stand a chance of appreciating in price as the Fed attempts to reflate," said Gross.

It also has been reported that Microsoft co-founder Bill Gates' charitable foundation has bought more than $2 billion in TIPS as a hedge against inflation.

If you think it may be time to give your portfolio some inflation protection, you have some options in addition to TIPS. At least two new inflation-protection investments are on the scene -- Certificates of Deposit Inflation-Protected, known as CDIPs, issued by LaSalle Broker Dealer Services Division, and Inflation-Protected InterNotes, known as IPIs, issued by Incapital. And, of course, the very popular I-bond is becoming a mainstay for people concerned with inflation.

Let's look at the main features of each of them, starting with TIPS.

TIPS have been around since 1997. The Treasury uses the Consumer Price Index as a guide to adjust the principal for inflation on a semiannual basis. A fixed interest rate is paid semiannually on the adjusted principal. At maturity, if deflation has decreased the value of the security, you'll still receive the original principal.

Newly issued TIPS can be purchased, without any fee, in January and July directly from the government through its TreasuryDirect program. Purchases throughout the rest of the year can be made on the secondary market through investment professionals, banks and brokers. Those purchases will involve a fee or commission.

TIPS are sold with 10-year maturities and can be purchased for a minimum of $1,000 and multiples thereof.

Because of the inflation protection, TIPS typically offer a lower rate of interest than other 10-year Treasury securities that don't have the feature. TIPS are subject to federal income tax, but not state or local taxes.

Keep in mind that in addition to paying tax annually on the interest you receive, you'll also have to pay tax each year on any increases to the principal, even though you won't receive the inflation-adjusted principal until the bond matures. For this reason, it's best to hold TIPS in a tax-deferred account or a Roth IRA.

Tom Grzymala, certified financial planner and principal at Alexandria Financial Associates in Alexandria, Va., advises individual investors to purchase TIPS through mutual funds rather than buying individual securities.

"When it comes to bonds, unless you can buy a minimum of $50,000 or $100,000, you're going to suffer with a bond broker when it comes to cost. They build the commission into the price you're paying. When Bill Gross buys bonds, he's buying millions of dollars' worth and you get the advantage of that pricing when you buy the fund."

There's an important difference to remember when considering buying individual TIPS vs. buying a TIPS bond fund. You're always certain of getting your full principal if you hold an individual bond until maturity. Sell before maturity and you'll get the current price and risk losing principal.

On the other hand, there is no maturity date when you buy shares in a bond fund. While the individual bonds that make up the fund have maturity dates, the fund itself does not. You should plan to hold your shares for the long haul and sell them when it's most advantageous to you.

In addition to Pimco, several other companies offer inflation-protected bond funds, including Fidelity and Schwab. Most funds will be no-load, but you may have to pay transaction costs.

Click here to learn more about TIPS.

Certificates of Deposit Inflation-Protected
CDIPs (pronounced C-DIPs) are very similar to TIPS, but LaSalle officials say they've improved on the Treasury's product.