TIPS for Dodging Inflation

A couple of weeks ago, I talked about the basics of Treasury notes, explaining how yields go up when prices go down, and noting that this often happens when traders are concerned about the possibility of rising interest rates. Of course, a key driver of higher interest rates is the fear of inflation, and generally speaking, buying Treasury notes during periods when the market is worried about rising inflation (like, say, right now) isn't a great idea. But if you hold stocks like Home Depot (NYSE: HD  ) or Wal-Mart (NYSE: WMT  ) that could be hurt by rising interest rates, putting a chunk of your portfolio into Treasuries might seem like a good idea anyway. What's a Fool to do?

Enter TIPS
The folks at the Treasury aren't dumb -- they've known for a long time that investors are unlikely to pay top dollar for their Treasury securities when inflation may be on the rise. About 10 years ago, they introduced TIPS -- short for Treasury Inflation Protected Securities -- hoping to ease the fears of potential investors who were worried about inflation. Their wish was granted: TIPS, which are available in five-, 10-, and 20-year maturities, have become quite popular among institutional and individual investors looking for some measure of inflation protection in the conservative segments of their portfolios.

The basics
Like regular Treasuries, TIPS are denominated in multiples of $1,000, auctioned several times a year, and issued with a fixed coupon rate (sometimes called interest rate) set by the Treasury. When you buy TIPS, you'll receive an interest payment every six months. At maturity, you'll get a principal payment, representing the return of your original investment.

What makes TIPS special is that the principal -- what we'd call the face value or par value with a regular Treasury note -- increases with inflation and decreases with deflation, as tracked by the Consumer Price Index. Because the interest rate is applied to the adjusted principal, your interest payments will go up (and possibly down) over the life of the TIPS. (If the adjusted principal is lower than your original principal at the end of the term, you get your original principal investment back instead -- you won't lose money if the U.S. should happen to suffer an extended period of deflation.) Thus, the purchasing power of your original investment won't erode over time, as it would with a regular Treasury note, and your coupon payments will also rise somewhat with inflation. (Read this article by Fool John Dutemple for a nice example of how this works in practice.)

The caveats
There aren't many. TIPS, like all Treasuries, are exempt from state and local taxes, but the coupon payments are subject to federal income tax if your TIPS are held in a taxable account. In addition, those upward adjustments to principal count as taxable income as well, even though you don't get any cash for them until the end of the term. If you need to sell your TIPS before they mature, there's a liquid secondary market -- but as with any Treasury, you will get less for low-interest TIPS if you sell out early. Just as regular bonds lose value when interest rates rise, TIPS can fall in value when real interest rates -- rates adjusted for inflation -- go up. To compensate, the market will only buy your low-coupon TIPS if you offer them at a discount from the par or principal value. This won't matter to you if you plan to hold your TIPS until maturity, but if you think you might need to sell early, or you're buying a mutual fund that actively trades TIPS, keep in mind that the inflation protection that TIPS provide doesn't extend to the effects of rising real interest rates.

Finally, if you do decide that TIPS deserve a place in your portfolio, consider buying them directly from the U.S. Treasury via their excellent Treasury Direct system. It's a simple process, and there are no fees or sales charges.

To learn more about TIPS -- and bonds of all kinds -- take a stroll through the Fool's Bond Center. And if you're interested in income investments that can help keep you ahead of inflation, why not consider income-paying stocks? The Motley Fool's Income Investor newsletter provides easy-to-understand investment ideas for Fools looking to boost income from their portfolios. Help yourself to a free 30-day trial and start learning more (and earning more) today.

Fool contributor John Rosevear does not own any of the stocks mentioned in this article. Wal-Mart and Home Depot are Inside Value recommendations. The Motley Fool has a disclosure policy.


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