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This Inflation Fighter Isn't Bulletproof

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Whenever you hear someone tout the perfect investment, keep listening for the catch. Even the most useful investments aren't the best place to put your money 100% of the time. TIPS are only the latest example.

Short for Treasury Inflation-Protected Securities, TIPS offer an extremely valuable feature that most bonds lack. In addition to paying regular interest with a guarantee for the repayment of principal at maturity, TIPS also adjust their value upward in line with rising inflation, as measured by the Consumer Price Index. But despite this protection, TIPS remain vulnerable to some of the same problems that plague other types of bonds.

Fighting inflation
On any given day, the Treasury assigns an inflation index ratio to each issue of TIPS, calculated from the most recent inflation data. If the CPI goes up by a certain amount in a given month, the inflation index ratio rises in lockstep. When TIPS reach maturity, you receive the original face amount, multiplied by the inflation index ratio for the maturity date.

Over time, this appreciation can be considerable. The index ratio for TIPS issued back in 1998 is currently 1.336, meaning that every $1,000 invested in TIPS is now worth $1,336. At least according to the CPI, the purchasing power of that $1,336 is equal to what your original $1,000 could buy 12 years ago.

Protection worth having
However, inflation hasn't been much of an issue over the past decade or so. That $336 rise in TIPS equates to just 2.5% annually. If that rate rose to just 4%, a 10-year TIPS could see a rise of almost 50% over its lifespan.

Inflation can cause huge damage to a long-term portfolio. Even if your investments stay stable, they lose real value -- and some investments, such as standard bonds, even see their prices fall during inflationary periods.

What about that catch?
It's true that inflation often moves interest rates. When inflation rises, TIPS will protect you. But there are other reasons why interest rates rise and fall. As the economy strengthens, the demand for capital rises, and investors start demanding higher real returns on their money. That, in turn, can push prevailing interest rates on TIPS higher. And when that happens, their value falls, just like any other bond.

So how can you best protect yourself against inflation, while not leaving yourself open to interest rate risk? There are a number of ways to offset the potential damage of owning TIPS during an economic recovery:

  • Own cyclicals. Cyclical stocks, such as FedEx (NYSE: FDX  ) , Dell (Nasdaq: DELL  ) , and Chevron (NYSE: CVX  ) , have much of their success tied to the fortunes of the economy. If you believe that TIPS will lose some value as the economy grows, gains from cyclical stocks could offset those losses.
  • Invest in commodities. Inflation is all about prices. Investing in things whose price rises with inflation can bring profits. Alternatively, you can invest in the companies that produce those things -- such as miner BHP Billiton (NYSE: BHP  ) or meat producers like Tyson Foods (NYSE: TSN  ) .
  • Go for dividends. Conversely, if the income that TIPS provide is an essential component of their appeal to you, dividend-paying stocks can help replace some of that income, while also benefiting from an improving economy. Companies such as McDonald's (NYSE: MCD  ) and Intel (Nasdaq: INTC  ) not only pay good dividends, but also stand to gain from greater consumer and business spending.

Take this tip
With interest rates on TIPS relatively low right now, it's important to remember that they're not free of investment risk. As part of a concerted strategy to protect your portfolio, however, they can play an extremely useful role in fighting inflation.

The biggest threat to your portfolio isn't what you think. Find out from Matt Koppenheffer how these three companies are shortchanging you.

Fool contributor Dan Caplinger isn't bailing out of his TIPS, but he doesn't expect to hold all his gains, either. He doesn't own shares of the companies mentioned in this article. FedEx is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a buy calls position on Intel, which is a Motley Fool Inside Value selection. Try any of our Foolish newsletter services free for 30 days. Here's a tip for you: The Fool's disclosure policy is a lean, mean fighting machine.

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