With the stock market still down by roughly 50% since its peak back in 2007, bond investors have made out like bandits. Yet while having some bonds in your portfolio makes a lot of sense, you can't expect to reach your financial goals solely by owning bonds -- even bonds that give you inflation protection.

Lately, many bond experts, including PIMCO's Bill Gross and Yale endowment manager David Swensen, have talked up inflation-protected bonds, also known as TIPS, as a strong investment opportunity right now. Although I agree that TIPS are a better investment than bonds that don't have inflation protection built in, putting all your money into them is a bad bet.

Staying safe is dangerous
Investors have been able to buy inflation-protected bonds for over 10 years now, but they've never taken off like the regular Treasury market. One reason is the relatively small supply -- while the Treasury has lately issued record amounts of debt to finance trillion-dollar bailout packages, issuance of TIPS has remained a relatively small part of the government's financing program. Right now, TIPS make up less than 8% of all Treasury securities held by the public. And given the low rates available to the Treasury on conventional bonds, there's no reason for it to expand TIPS offerings.

Even though a dose of TIPS can help you hedge against inflation, they definitely aren't the perfect investment. Here are just a few of their drawbacks:

  • Although TIPS pay you a fixed return above the rate of inflation, all of the income they generate gets taxed. That means that after taxes, you could end up with a real return less than zero -- especially if inflation is particularly high.
  • TIPS rely on the methodology that the Department of Labor uses to calculate the consumer price index. So, if you have doubts that the official CPI statistics really track your personal inflation rate, then TIPS may not provide you the hedge you need.
  • Despite the fact that TIPS rise in value with inflation, you don't actually get paid the inflation adjustment until your TIPS mature. With maturities of 20 years or more, that's a long time to wait before reaping the benefits of an inflationary environment.

Moreover, you need to protect your portfolio from every threat, not just inflation. In particular, let's look at a few other concerns people have now.

There's a big debate over whether the potentially inflationary policies of the government can overwhelm the deflationary tendencies of the cratering housing markets, as well as the drop in stocks. Prolonged deflation would hurt debt-laden consumers and businesses, as they'd have to pay back outstanding loans even as incomes and asset values fell.

Clearly, TIPS wouldn't protect you against the threat of deflation. Most stocks wouldn't either, although industries that have large exposure to raw materials costs, such as utilities Sempra Energy (NYSE:SRE) and PPL (NYSE:PPL), could hold up fairly well.

Stream of income
Most of the time, people buy bonds for income as well as capital preservation. But TIPS don't pay much income, with some TIPS paying less than 1% in interest annually. And while income payments on TIPS rise with inflation, they won't grow any faster.

For a stream of income with better growth potential, you might consider dividend stocks with enough pricing power to pass through higher costs in an inflationary environment. Those would include industry powerhouses like the following:



Current Div. Yield

5-Year Dividend Growth Rate

Procter & Gamble (NYSE:PG)

Personal products



Johnson & Johnson (NYSE:JNJ)

Health care



Coca-Cola (NYSE:KO)

Soft drinks



McDonald's (NYSE:MCD)




Chevron (NYSE:CVX)




Source: Yahoo! Finance, DividendInvestor.com.

These companies not only sport payouts much higher than bonds, but they have also seen their dividends grow much faster than inflation. That could make a huge difference to your portfolio if inflation does strike.

You can have it all
TIPS can play a useful role in your portfolio, but don't rely on them too much. By combining TIPS with other investments that better cover all the risks you face, you can be sure you'll be protected in any market environment.

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