Investment Tip: Be Cautious With TIPS

By Dr. Don Taylor, Ph.D., CFA,

Dear Dr. Don,My husband and I have a total of $190,000 to invest. I was thinking of buying Treasury inflation-protected securities, or TIPS, as an investment. I won't need this money for at least 10 years. What do you think?-- Judy Jumpin'

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Dear Judy,The market for Treasury inflation-protected securities has had a great run this year along with the overall U.S. Treasury market. I own a mutual fund that invests in TIPS, and it's the only security in my portfolio that has a positive, double-digit, year-to-date return. If you decide to buy TIPS, you have to choose whether to own them outright as securities, inside a mutual fund or as an exchange-traded fund, or ETF. If you are a do-it-yourself investor, the ETFs and mutual funds have the advantage of professional investment management, but you don't control how the investment manager invests in these securities.

The attraction for investing in TIPS is you're guaranteed to earn a rate of return equal to the inflation rate as measured by the Consumer Price Index, or CPI. You also earn a fixed yield. It's the fixed rate that can increase your purchasing power over time. The inflation adjustment just preserves your purchasing power.

I would be hesitant to buy into this investment after the run-up in TIPS prices. Ideally, you'd like to earn the inflation-adjusted return plus somewhere between 1% and 3% on the fixed rate. You would need to buy the 30-year maturity to get a yield that meets that target. That 30-year issue was priced as a new issue at auction in February 2011 to yield 2.19% with a 2.125% coupon. Buy it in the open market today, and you're paying a 28% premium to its $1,000 face value, and it's priced to yield just 1% more than the inflation rate. You'd have to wait until the Treasury marketed a new issue 30-year TIPS in February 2012 to avoid paying a high premium to own the outstanding issue.

Buying 30-year bonds when you have a 10-year investment horizon can have you taking on more risk than appropriate in your portfolio. A bond's duration is a better measure of its price risk than its maturity, but the 30-year TIPS is still too long a maturity for your portfolio.

If you have a taxable account, there are disadvantages to investing in TIPS. One is that you have to pay income tax on the inflation-adjusted return in the tax year that it's earned, but you don't receive that income until the bond is sold or matures. Owning TIPS inside of a tax-advantaged retirement account solves this problem for most investors, with no taxes due on the inflation adjustment until distributed in a tax-deferred account and balances growing tax-free inside a Roth IRA account.

A double-dip recession could take the inflationary pressures off the table, at least for a period of time. While TIPS guarantee inflation protection, you can expect their market value to fall if the rate of inflation falls. Risking all of your investable assets on this one type of investment isn't a good idea. They are better as part of a portfolio than they are as the whole portfolio.

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