A TIP for Inflation-Fearing Investors

To find gains in the Dow last year, you had only two choices: Wal-Mart (NYSE: WMT  ) and McDonald's (NYSE: MCD  ) . Yet while bonds were equally volatile, segments of the bond market did extremely well in 2008.

In the fixed income, market volatility was ever-present as well. Bonds of Hawaiian Telecom, which was once owned by Verizon (NYSE: VZ  ) , had the distinction of losing over 99% of their value as Hawaii's only local telecom declared bankruptcy. Meanwhile, the bonds of Alltel were among the best performers in the high-yield bond sector, rising 27% as a result of a buyout bid led by Verizon.

If the turbulence of the stock and bond markets have you looking for a unique but more sedate ride with your investments, an ETF that invests in inflation-protected treasury securities might be of interest.

Fund specifics
Fear of deflation seems so last year. But with Washington in a spending frenzy, providing money to institutions ranging from automaker General Motors (NYSE: GM  ) to financial services giants like Bank of America (NYSE: BAC  ) , Treasury Inflation-Protected Securities (TIPS) may provide a necessary antidote to a world that faces a serious long-term inflation risk.

Unlike traditional bonds, the principal value of TIPS increase with inflation and decrease with deflation, as measured by the Consumer Price Index. When a TIPS bond matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS also pay interest, and since the rate is applied to the adjusted principal, the interest rate also rises with inflation and falls with deflation.

Investors have two inflation-protected bond fund ETFs to choose from: the iShares Barclays TIPS Bond ETF (NYSE: TIP  ) and the SPDR Barclays Capital TIPS ETF (NYSE: IPE  ) . There are also traditional mutual funds such as the Vanguard Inflation-Protected Securities Fund (VIPSX) for investors who prefer them.

Among the two ETF options, the funds are very similar in their expenses and performance. But the iShares fund has around 50 times the assets of its rival, along with far greater trading volume.

Fund facts

Fund

2008 Return

Yield

Expense Ratio

Assets

SPDR

(2.3%)

5.97%

0.19%

$144 million

iShares

(2.5%)

6.46%

0.20%

$7.9 billion

Source: Morningstar, iShares, SSgA.

Fund prospects and risks
Treasury securities have the government's guarantee of timely interest and principal payments, which has been very attractive to many investors over the past few months. That strong demand has driven yields on Treasury securities to unprecedented lows, leaving little room for further interest rate declines. Conjecture that the Treasury market is the next bubble to pop, and the low yields offered are enough to put me off these securities, but TIPS are one way to get the security of U.S. Treasury securities along with returns that will reflect inflation going forward.

Portfolio fit?
From a broader perspective, the U.S. government's fiscal and monetary stimulus is likely to have an impact on inflation, as money supply increases from government credit policies and prices on goods rise on higher demand due to infrastructure and other spending programs. That could push interest rates up. TIPS provide inflation protection and modest return potential, giving investors a safe haven in which to place a portion of their investment portfolio.

Both the inflation adjustment to principal and the interest payments on TIPS are taxable as ordinary income for federal income tax purposes, which means a TIPS fund might be more suitable for retirement accounts.

In these turbulent times, a TIPS fund may be just what the doctor ordered. In my eyes, the slightly higher return of the SPDR fund is more than offset by the larger asset base of the iShares fund, and I would tip my hat to the fund with the most liquidity.

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Fool contributor Zoe Van Schyndel lives in the Seattle area, where she enjoys the coffee and natural wonders. She does not own any of the funds or securities mentioned in this article. Bank of America is a Motley Fool Income Investor recommendation. Wal-Mart is a Motley Fool Inside Value selection. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 15, 2009, at 11:35 PM, weiwentg wrote:

    The investing thesis misses the fact that the US government is going to have to borrow huge sums to fund the stimulus plan. It's true that TIPS are attractive relative to regular Treasuries, but I believe that Treasuries are trading at temporarily depressed yields due to a flight to quality. As the US government increases its borrowing and its creditworthiness comes into question, people are going to sell Treasuries and drive up their yields. The prices on TIPS will probably trade in line with Treasuries. I think I'll hold off a bit before buying.

  • Report this Comment On January 16, 2009, at 7:28 AM, weiwentg wrote:

    The investing thesis misses the fact that the US government is going to have to borrow huge sums to fund the stimulus plan. It's true that TIPS are attractive relative to regular Treasuries, but I believe that Treasuries are trading at temporarily depressed yields due to a flight to quality. As the US government increases its borrowing and its creditworthiness comes into question, people are going to sell Treasuries and drive up their yields. The prices on TIPS will probably trade in line with Treasuries. I think I'll hold off a bit before buying.

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