Slam-Dunk Investment TIPS for 2009

I get interested when two of the most successful investors of our time single out the same investment opportunity. In January, Bill Gross recommended the purchase of Treasury Inflation-Protected Securities, or TIPS, in a note to clients. As the co-chief investment officer of bond giant PIMCO, Bill Gross oversees the management of more than $800 billion in fixed-income securities. Bill knows bonds.

Wait!
Now, before you move on because I'm talking about bonds, I assure you there is a lesson here for all investors who wish to protect their assets -- even those who consider themselves purely stock investors.

In a recent interview, David Swensen, who manages Yale's $23 billion endowment, mentioned TIPS as an investment he likes. His take? "They promise reasonable returns, and protection against inflation is really important." (Swensen has achieved a 16% annualized return for Yale over the 10-year period ended in June -- a remarkable achievement.)

What are TIPS?
Treasury Inflation-Protected Securities do exactly what they say on the box. They are U.S. Treasury bonds designed specifically to protect investors against inflation. To do that, both the interest and the principal payments are indexed against the Consumer Price Index. So the yield quoted on a TIPS is a "real" return -- that is, an incremental return over the rate of inflation.

When comparing a TIPS and an ordinary Treasury bond (T-bond) of the same maturity, it's possible to assess which one is the more attractive investment by comparing the difference in their yields and deriving the "breakeven inflation rate" -- the rate for which the total return on the TIPS will be equal to that of the T-bond. If the breakeven inflation rate is lower than the actual inflation rate during the period to the bond's maturity, the TIPS will provide a higher overall return than the ordinary T-Bond.

Will the next 10 years be deflationary?
At the moment, the yield on the 10-year TIPS is 1.25% versus 2.74% for a T-bond, implying a break-even inflation rate of just 1.49% annually over the next 10 years. Is that scenario possible? Absolutely. In fact, rolling-10-year average inflation rates were lower than this in every month from July 1928 through April 1942.

Still, I think it's pretty unlikely (it has only recurred in 40 months since World War II, in the years 1961 to 1964). While we could witness deflation this year and the next, it's difficult to imagine that prices 10 years from now will be a mere 15% higher than they are today. If that is the case, it’s more likely the new administration will have been unsuccessful in its efforts to reinflate the economy with its "bridge-to-the-moon" fiscal stimulus package.

Of course, part of the discrepancy is because of the tremendous overvaluation in Treasury bonds that I highlighted in "A Slam-Dunk Trade for 2009." The surest way to take advantage of the mispricing would be to go long TIPS and sell short same-maturity Treasury bonds -- although I wouldn't necessarily recommend such a strategy for retail investors.

The equity version of TIPS
If you're entirely committed to stocks, there is a segment of the stock market that could be thought of as the equity version of TIPS: high-quality dividend stocks. A well-run dividend payer should be able to increase its dividend at a rate that matches or exceeds inflation, and as the following table demonstrates, there are superb companies currently paying yields that exceed those on Treasury bonds:

Source: Capital IQ, a division of Standard & Poor's.

Note that two of the seven stocks (Abbott Laboratories and Consolidated Edison) are part of the S&P 500 Dividend Aristocrats -- an elite group of dividend stocks, all of which have increased their dividends for at least 25 years consecutively.

(By the way, if you think that the comparison between stocks and Treasury bonds is absurd, you should know that Warren Buffett has been known to analyze stocks by treating them as "disguised bonds.")

All dividend stocks aren't created equal
Of course, there is a fundamental difference between investing in TIPS and stocks -- with the latter, neither your principal nor your dividend is guaranteed. It is therefore essential to focus on the highest-quality names and buy only when you can do so with a margin of safety. That is the sole focus of the team at Motley Fool Income Investor, our dividend stock service. If you'd like to start building an armor-plated portfolio of dividend stocks, sign up for a 30-day free trial now.

This article first appeared on Jan. 24, 2009. It has been updated.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Alcon is a Motley Fool Global Gains recommendation. Kraft Foods is a Motley Fool Income Investor selection. The Motley Fool has a disclosure policy.