Protect Your Retirement Portfolio From Inflation: Buy TIPS

Photo: Investors who can recall double-digit inflation in the late 1970s are worried. If you are in agreement and wish to immunize your portfolio then you should be giving a close look at TIPS -- or Treasury Inflation-Protected Securities

Investors who can recall double-digit inflation in the late 1970s are worried.

For the past nine months, they note, the federal government has pumped trillions of government dollars into the nation's financial bloodstream. Sooner or later, they figure, an inflationary fever is sure to strike.

If you are in agreement and wish to immunize your portfolio, then you should be giving a close look at TIPS -- or Treasury Inflation-Protected Securities. Forget about gold. TIPS are the one investment guaranteed to keep pace with inflation.

Backed by the full faith and credit of the U.S. government, TIPS are as secure as any other U.S. Treasury security and are designed to ensure investors do not lose ground to rising consumer prices. They won't make you rich over the long haul, but they will protect you against lost purchasing power.

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They may be particularly appropriate for investors who worry about inflation but remain skittish from the past year's market losses and are reluctant to make a major commitment to stocks again.

As with any investment, just be sure you don't go overboard with TIPS. These government bonds should be one piece in the fixed-income side of your portfolio. An appropriate TIPS allocation might be around a quarter of your overall bond allocation.

So what are TIPS and how do they work?

TIPS are federal government bonds whose principal and interest payments are adjusted for inflation as the Consumer Price Index for Urban Consumers (CPI-U) rises and falls on a monthly basis. They are issued in terms of five, 10 and 20 years through a competitive auction that sets the fixed interest -- or coupon -- rate.

TIPS Can Stabilize Your Portfolio

TIPS adjust for inflation in two ways as changes are made to the principal amount.

First, twice-a-year interest payments adjust in line with changes to the principal. Even though the coupon rate itself does not change over the life of an individual TIPS bond, the actual interest payment will rise or fall in tandem with changes to the principal amount.

For instance, say a $1,000 TIPS bond is issued with a 2 percent coupon rate. Initially, that amounts to $20 in annual interest payments. But if the principal amount adjusts up to $1,030 on 3 percent inflation, then the new annual interest payments will total $20.60 based on the 2 percent coupon rate.

Second, at maturity, the U.S. Treasury will pay a TIPS owner a higher principal amount if inflation over the years has driven up the principal value. Assuming 3 percent annual inflation, a 20-year TIPS bond with an initial principal value of $1,000 could be worth more than $1,800 at maturity.

What if the United States encounters a prolonged period of deflation? Then the U.S. Treasury will pay the TIPS owner the original face value, offering downside protection for the investor.

Attractive as this sounds, keep in mind there are drawbacks to owning TIPS.

One drawback is that TIPS generally pay less than traditional Treasuries of similar terms. For instance, a 10-year TIPS note currently yields about 1.7 percent compared to 3.2 percent for a traditional 10-year Treasury.

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