You'd have to live in a bunker not to know how much prices have risen lately. From milk to gas, health care to college tuition, one thing you can count on is that you're seeing your living expenses skyrocket.
Ideally, your investments will grow enough to compensate for those higher expenses. But how do you protect your portfolio against inflation without taking on too much risk in the stock market? The answer is simple: inflation-linked bonds.
Financial innovation at work
In the 1990s, the U.S. government started auctioning Treasury Inflation Protected Securities, or TIPS, as one of its regular products to finance the national debt. These securities offered investors an alternative to traditional Treasury bonds.
With regular Treasury bonds, you pay around $1,000 per bond, receive interest payments over the term of the bond, and at maturity, you get your $1,000 back. But after a number of years of maturing, the $1,000 you get back has a lot less purchasing power than the $1,000 you originally invested.
With TIPS, however, your maturity payment is adjusted upward for inflation. For instance, if you buy 10-year TIPS for $1,000 and inflation rises 30% over those 10 years, then you'll get $1,300 at maturity.
Securities that offer similar protection from inflation have become increasingly popular over time. The corporate side of the market started slowly, with Fannie Mae (NYSE: FNM ) being the big player early on. Gradually, other companies -- Sallie Mae (NYSE: SLM ) , Morgan Stanley (NYSE: MS ) , Bear Stearns (NYSE: BSC ) -- began to offer corporate bonds in 2003-04 that were linked to inflation.
In addition, ABN AMRO's (NYSE: ABN ) LaSalle Bank offers CDs with returns that adjust with inflation. The firm Incapital has marketed inflation-linked securities under the name Internotes, with issuers like Prudential Financial (NYSE: PRU ) .
Protecting your income
At our Rule Your Retirement newsletter, Foolish expert Robert Brokamp has suggested that dividend-paying stocks are a solid way to preserve an income stream that will keep up with inflation. But in this month's issue, which comes out today at 4 pm ET, he notes that even high-yielding stocks are prone to market downturns, making bonds an essential part of your portfolio. And while traditional bonds can drop precipitously if inflation heats up -- which is a real danger now -- TIPS provide real protection against inflationary spikes.
There are many ways to buy inflation-linked bonds. You can buy TIPS directly from the Treasury Department through its Treasury Direct website; auctions are held quarterly with a variety of maturities ranging from five to 20 years. An exchange-traded fund, the iShares Lehman TIPS ETF (NYSE: TIP ) , makes TIPS available to shareholders. Several traditional mutual funds also offer TIPS as investments.
Many fear that the Federal Reserve's dramatic response to the slowing economy may reignite inflation. If so, having an arsenal of TIPS in your portfolio will help protect you from a rapid drop in the the purchasing power of your savings.
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