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Hot TIPS to Heed

Bonds?You recommend bonds?
Not just any bonds -- TIPS are U.S. Treasury-issued bonds that, like the more familiar T-Bonds, are backed by the full faith and credit of the U.S. government. Unlike Treasury bonds, however, TIPS aren't subject to the eroding purchasing power that fixed-income securities normally suffer from. Thus, TIPS offer the safety of government backing with protection from inflation. The trade-off is that investors don't know the payments from TIPS up front, and TIPS offer a lower coupon than Treasuries. This last issue is not as big a deal as it seems, once you understand how TIPS work. In addition, the TIPS come in fewer maturities (five-, 10-, and 20-year) than Treasuries.

The mechanics
Let's compare 10-year TIPS with 10-year Treasuries.

When you purchase a 10-year Treasury with a coupon of 5% for $1,000, you'll receive an interest payment of $25 (5% multiplied by 1,000, divided into two installments) in six months and every six months after that; at the end of 10 years, you'll get your $1,000 back.

When you buy a TIPS at issue, you still pay the $1,000, but you're looking at a lower coupon rate of, say, 2%, and you will receive an interest payment of $10 in six months. The inflation protection occurs as your original face amount of $1,000 increases at the rate of inflation.

If inflation is 3%, your face amount increases to $1,030 by the end of the year. Furthermore, the next coupon is based on the new face amount, so the coupon is now $10.30 (2% multiplied by $1,030 divided into two payments per year). In addition, should inflation continue at 3% for the entire 10-year period, you would receive $1,343.92 at the end of 10 years, not the $1,000 you invested (and would expect to receive from Treasuries at maturity). In effect, the 3% difference in coupon is the expected inflation for the period, and if inflation turns out to be exactly that, you'd be in the same place after the effects of inflation. Of course, the actual return on the TIPS depends on the behavior of inflation over the 10-year period. This is important to know, especially for retired investors, whose biggest threat comes from inflation's erosion of purchasing power. Returns on TIPS rise and fall in sync with inflation, with one big exception: If inflation falls below zero -- a condition known as deflation -- TIPS are guaranteed to return their face value.

The catch: taxes
For taxable accounts, it's important to know how TIPS are taxed to avoid nasty surprises. TIPS, like all Treasury securities, are exempt from state and local taxes; however, the treatment of the increase in face value that sets TIPS apart.

When you receive the 5% coupon on Treasuries, you are taxed on the entire amount at the current rate for ordinary income. With TIPS, to keep the playing field level, you are not only taxed on the coupon, but also on the increase in face amount. In our illustration, that means you are taxed on the $20 you get from the two coupon payments plus the $30 increase in face amount -- the same position you would be in with the Treasuries.

Risk-free?Not exactly
One of the nice things about bonds is that, barring default, you know exactly how much money you're going to get and when if you hold the bond to maturity. Does this mean the value of your investment can't drop?

To the contrary, there have been times when bonds have shown more volatility than stocks. Even so, you can be assured of getting the face amount back at maturity. In the interim, interest rates are what primarily determines a bond's value.

When interest rates rise (as they have been), bond prices fall (and vice versa). This is because companies and governments are offering new debt with higher coupons. To make the older, lower-coupon bonds in circulation equally attractive, they now have to trade hands for less. For Treasuries, the key determinant is the nominal interest rate; for TIPS it's the real interest rate. If you hold TIPS directly with a laddered maturity schedule and don't plan to sell them before they mature, you probably don't care, and you may not even know that your holdings have fluctuated. If, on the other hand, you hold TIPS in a mutual fund, the drop in value can be pronounced.

A not-so-boring opportunity
Why bring this up now? Well, real interest rates are hovering around three-year highs, providing a couple of opportunities.

First, high real yields are available to the fixed-income investor. A guaranteed return of nearly 2.5% over inflation can be had without the risk of stocks, which, according to some analysts, have a risk premium not too much greater than that currently baked into their price.

Second, real rates tend toward a long-term average (a phenomenon known as mean reversion). Note: This is not true of nominal rates, which are not adjusted for inflation. As the current relatively higher rates unwind, we can expect gains. But be warned -- mean reversion is a tendency, not an ironclad rule of nature, and many things could drive real rates further out of whack: Another attack on the U.S., rampant deficits, or a shift to another currency as the de facto world currency.

In short, TIPS have a place in many investors' portfolios for the long term, and they may be ripe for short-term opportunities as well.

TIPS are ideal for anyone who's planning for retirement. For more retirement tips, try a free trial toRule Your Retirement.Our calculators can help, and you can try them free for a month -- and get advice on the newsletter's discussion boards.

Fool contributor John Dutemple is the president of Compton Advisors LLC, a Missouri-based registered investment adviser firm. He owned no TIPS when this was published. The Motley Fool has a disclosure policy.


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