Time for TIPS

Treasury inflation-protected securities (TIPS) have always bored me. They're unexciting, they usually offer puny returns, and they take some time to understand.

But there's a time for every investment, and now is the time to add TIPS to your portfolio. They're outrageously cheap, and they protect you against inflation, which is virtually certain to pick up in the coming years.

Bill Gross, manager of Pimco Total Return (symbol PTTDX) and other similar funds, notes that although the market has punished TIPS lately, their prices could quickly reverse course once investors begin to anticipate an economic recovery. Gross says a sharp rally in TIPS prices is likely within the next six months.

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Here's how TIPS protect you against inflation. Every six months, the government resets the value of your TIPS based on the rise in the Consumer Price Index. TIPS immediately start paying interest on that higher amount of principal.

With the government running the printing presses 24 hours a day in an effort to ward off deflation, it's hard to believe the U.S. won't see a pickup in inflation once the financial crisis abates. "We like TIPS as an insurance policy on inflation," says Mark Kiesel, head of investment-grade bonds at Pimco.

But today's TIPS prices seem to suggest that future inflation will be practically nonexistent. A ten-year TIPS note currently yields about 2%, while a regular ten-year Treasury note yields only one-half percentage point more. That means that over the next ten years, TIPS will do better than regular Treasuries if inflation is more than a mere 0.5% a year. A five-year TIPS note yields 2.25% -- slightly more than regular Treasuries. In other words, even if there is no inflation over the next five years, TIPS will earn more than standard Treasury IOUs.

What accounts for this unusual state of affairs? First, the bond market is expecting deflation-that is, falling prices. Then there are the hedge funds, which are responsible for so many dislocations in all sorts of markets. When the economy was stronger, many hedge funds loaded up on TIPS-often using borrowed money-hoping to cash in on inflation. When investors started cashing out of hedge funds last year, their managers dumped TIPS-not because they wanted to, but because they could sell them easily.

Consumer prices have fallen over the past few months, and deflation is likely to continue for several more months. But I can't imagine deflation lasting for several years.

The Federal Reserve and the Obama administration are doing everything they can to protect against the kind of deflationary spiral that is associated with the Great Depression and Japan's financial crisis in the 1990s. Obama is pushing a massive stimulus program, and the Fed has lowered short-term interest rates to zero and is flooding the economy with money. "The economy faces huge hurdles, but gigantic amounts of fiscal and monetary stimulus are being applied," says John Hollyer, manager of Vanguard Inflation-Protected Securities (VIPSX).

Suppose deflation does continue for years to come. TIPS come with an added layer of protection against deflation: When they mature, the Treasury promises to pay back at least the amount you paid. In other words, if you buy TIPS and hold to maturity, you can't lose money.

You can buy TIPS directly from the federal government in increments as low as $100 at TreasuryDirect.gov. If you buy directly, it's best to hold TIPS in an IRA or other tax-deferred account. Otherwise, you must pay taxes annually on the "phantom income" that TIPS generate as they're adjusted in value to reflect increases in inflation.

The other way to buy TIPS is through a mutual fund or an exchange-traded fund-both of which eliminate the phantom-income problem. If you invest through a brokerage account, your best bet is iShares Barclays TIPS Bond (TIP), an ETF. Annual expenses are just 0.2%. The fund will drop in price by about 7% if interest rates on Treasuries rise by one percentage point.

For fund investors, the Vanguard fund is a better choice because you don't have to pay any commissions. Annual expenses are also 0.2%, and the fund is about as vulnerable to a rise in interest rates as the ETF is.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.

Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.