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Are Inflation-Indexed Bonds Finally a Buy?

By Dan Caplinger – Jul 5, 2013 at 9:30AM

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Protection from rising prices no longer comes with as high a price tag as before the bond-market swoon.

One of the biggest enemies investors face is inflation. Slowly but inexorably, the impact of rising prices robs purchasing power from your savings and investments, forcing you to find ways to make your money grow just to stay even in terms of what you can actually buy. Yet one promising inflation-fighting investment -- inflation-indexed bonds -- promised to help investors fight that risk.

For a long time, prices of inflation-indexed bonds climbed so high that they were unreasonable to buy. Now, though, those prices have seen a major correction, thanks to the recent plunge in the bond market -- and suddenly, investors with long time horizons are looking more closely at one particular type of inflation-indexed bond known as Treasury Inflation-Protected Securities, or TIPS. Later in this article, we'll analyze why TIPS are getting more appealing, but first, let's take a look back at how TIPS came to be and why they marked a true innovation in the bond-investing arena.

Why TIPS changed the bond world
When inflation-indexed bonds became available in the late 1990s, they transformed the bond market entirely. Ordinarily, bond investors are scared to death of inflation, as the only thing that most traditional bonds give you to offset eroding purchasing power is a stream of interest payments -- and those have been perilously small lately.

But when the Treasury issued its first TIPS in 1997, it represented a new way of thinking about bond investing. Rather than simply paying a stream of interest until maturity and then returning the face value of the bond to investors, TIPS also incorporated inflation adjustments into the value of the bond. So if you bought a 10-year TIPS issue with a face value of $1,000, you would get semi-annual interest payments at a specified rate just like with normal Treasury bonds, but at maturity, you'd get more than $1,000 -- with the amount of the increased value matching the change in the Consumer Price Index between when the bond was auctioned and when it matured.

Admittedly, inflation hasn't been a huge concern over the past several years, as most prices have remained under control given the relative weakness of the economic recovery and the resulting inability for companies to impose pricing power on consumers who are struggling under high unemployment rates and weak wage growth. But long-term investors nevertheless keep an anxious eye on prices to stay aware of any signs that inflation could come back.

Why TIPS are back
The good news for would-be TIPS investors is that yields have risen dramatically on the bonds in light of the overall weakness in bond prices recently. Until recently, TIPS with maturities of up to 20 years sported negative real rates -- meaning that investors not only would get minimal interest payments while they held their TIPS but also would have to pay up to buy the bonds in the first place, with the price being high enough that even with the inflation adjustment, the bonds were guaranteed to lose purchasing power.

But lately, prices of existing TIPS have plunged, and that has sent real yields back into positive territory. TIPS with a 10-year maturity yield about 0.5%, while 20-year TIPS pay almost 1% above inflation and 30-years are yielding about 1.25% in real terms. Similarly, the TIPS ETF iShares Barclays TIPS Bond (TIP 1.29%) has lost about 7.5% of its share-price value since the beginning of May, but its average real yield to maturity has gotten back to the break-even point.

International bond investors can get even better real yields if they're willing to accept currency risk. iShares International Inflation-Linked Bond (NYSEMKT: ITIP) offers a real yield of more than 1.5%, with a wide range of exposure to sovereign debt from countries including Brazil, the U.K., France, and Italy.

Not all inflation-indexed bonds have become attractive, though. iShares 0-5 Year TIPS Bond (STIP 0.74%), which keeps a short average maturity of less than two-and-a-half years, still has a negative average real yield of -0.7%. The competing Vanguard Short-Term Inflation-Protected Securities ETF (VTIP 0.69%) has a similar issue, with the fund expecting only minimal total yields even after accounting for inflation.

Tips on buying TIPS
One thing to keep in mind with TIPS is that it's usually smartest to buy them in a tax-deferred account. Otherwise, you can pay tax even on money you haven't received yet, because the IRS treats the inflation adjustment as income in the year the adjustment is made, even though you won't actually pocket the extra cash until maturity.

But whether you go through an ETF or buy TIPS directly from the U.S. Treasury, inflation-indexed bonds are a great way to protect your bond portfolio from the prospect of rising prices. When no one's really worried about inflation, now's a great time to consider whether you should pick up TIPS for your portfolio on the cheap.

Apart from the impact of inflation, taxes are the biggest threat to investors' long-term returns. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "How You Can Fight Back Against Higher Taxes," the Motley Fool's tax experts run through what to watch out for in doing your tax planning this year. With its concrete advice on how to cut taxes for decades to come, you won't want to miss out. Click here to get your copy today -- it's absolutely free.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

iShares Trust - iShares TIPS Bond ETF Stock Quote
iShares Trust - iShares TIPS Bond ETF
TIP
$106.25 (1.29%) $1.35
iShares Trust - iShares 0-5 Year TIPS Bond ETF Stock Quote
iShares Trust - iShares 0-5 Year TIPS Bond ETF
STIP
$96.82 (0.74%) $0.71
Vanguard Malvern Funds - Vanguard Short-Term Inflation-Protected Securities ETF Stock Quote
Vanguard Malvern Funds - Vanguard Short-Term Inflation-Protected Securities ETF
VTIP
$47.53 (0.69%) $0.32

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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