May 19, 2009 -- 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.
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.
A second drawback for TIPS is that owners are taxed on annual increases in the principal value of a TIPS bond in the years before maturity even though the owner does not realize the benefit until the end of the bond's term. This is known as a tax on "phantom income" and means it is best to own TIPS inside an IRA or another kind of tax-deferred account. That will allow the owner to shield this phantom income from taxation until the funds are withdrawn from the IRA or other tax-deferred account.
TIPS Different from I Bonds
It also should be noted that TIPS differ in several ways from I-series U.S. Savings Bonds, which also adjust for inflation but in a different manner. I Bonds include a fixed earnings rate that remains the same, plus a variable that changes with inflation.
Other differences include the following: I Bonds are non-marketable, meaning they can't be bought or sold through a broker; I Bonds purchases are limited to $5,000 per year per person; and I Bonds interest accrues over the life of the bond and is paid upon redemption, rather than twice a year.
Finally, many individual investors may want to own TIPS through a mutual fund or exchange-traded fund that invests in TIPS. Examples include the Vanguard Inflation-Protected Securities Fund, American Beacon TIPS Fund, Fidelity Inflation-Protected Bond Fund, iShares Barclay TIPS Exchange-Traded Fund and SPDR Barclays Capital TIPS ETF.
A TIPS fund allows the investor to own a wide mix of TIPS of varying maturities and create a more diversified portfolio. Also, a TIPS fund avoids the phantom income tax problem. However, as with any bond fund, the investor in TIPS mutual fund or ETF is not guaranteed a return of principal as they may need to sell the fund at a time when its value is down due to market conditions.
But whether owned directly or through a fund, TIPS can be a sound way to help to stay a step ahead of inflation and a possible return to the 1970s.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at email@example.com.