Inflation is up. So why are inflation-shielded funds going down? By David Landis, Contributing Editor July 31, 2006 If you own a fund that buys inflation-protected bonds, you may feel as if someone punched a hole in your life raft. Just as inflation is picking up, the funds are sinking. They lost 2.2%, on average, in the first five and a half months of 2006. Among Morningstar's bond-fund categories, only long-term government bonds (down 6.4%) did worse. What kind of protection is that?What investors may not realize is that although TIPS (short for Treasury inflation-protected securities) provide protection from inflation, they're still vulnerable to a general selloff in the bond market. Inflation fears have pushed up interest rates lately, so bond prices, which move in the opposite direction, have fallen. "TIPS have not done extremely well, but they've done better than regular Treasuries," says Steven Bohlin, a bond manager at Thornburg Investment Management. Unlike traditional Treasuries, TIPS get biannual boosts in face value tied to rises in the consumer price index. And because the coupon payment is a fixed percentage of the face value, it rises as well. So TIPS owners who hold to maturity will get back their original investment plus their accumulated inflation adjustments. (Be aware: Inflation adjustments are taxable when you get them, even if you don't sell your TIPS.) A matter of pricing Thornburg's Bohlin thinks TIPS funds have performed poorly this year because the sector was overpriced. That is, buyers bid up the prices of TIPS last year until their yields were below historical levels. The yield on ten-year TIPS is currently 2.5%. That's up from 2% last December but still below the 3% inflation-adjusted return that investors have historically demanded, he says. Advertisement If you own individual TIPS and plan to hold them until maturity, there's little reason to worry about short-term price gyrations. But if you're currently in the market for TIPS, there are two considerations. The first is whether you think inflation over the next decade will outpace the 2.6% rate implied by the difference in yield between regular ten-year Treasuries (5.1%) and TIPS (2.5%). If so, TIPS might be worthwhile. The second is whether you are satisfied with the 2.5% coupon yield, which represents the after-inflation return. If not, look at other inflation hedges, such as commodities. For fund investors, recent returns highlight an often overlooked fact: You could get stuck with a loss if you buy a TIPS fund when prices are generally high. Long-term investors shouldn't lose sleep over these occasional hiccups. TIPS can be volatile in the short term, but over time their value tends to move in concert with inflation.