Don't Count on TIPS

Their inflation protection will likely be overwhelmed by their vulnerability to rising interest rates.

Treasury inflation-protected securities may rank as today's most over-hyped investment product. To hear their proponents talk, TIPS will shelter you from the ravages of inflation, which does seem likely to worsen. But they forget to mention that TIPS are Treasury bonds, which are almost certain to fall in value as inflation heats up.

The problem is that inflation and interest rates often move almost in lock step. Take the worst-case scenario from recent history: As measured by the Consumer Price Index (CPI), inflation hit 13.6% in 1980, and yields on the ten-year Treasury peaked at 15.8% the following year.

TIPS protect you from inflation with one hand, but they punish you with interest-rate hikes with the other. Remember: In the strange world of bond math, when yields rise, bond prices fall. TIPS rise in value with expectations of increases in the CPI, the government's chief measure of inflation -- albeit one that's widely criticized as understating the true inflation rate. But at the same time, TIPS prices fall as the price of other Treasury bonds do.

If you buy TIPS directly from the Treasury and hold them to maturity, you'll receive the full CPI increase. If you invest through a regular mutual fund or an exchange-traded fund, you're at the mercy of the market's expectations for the CPI.

TIPS probably won't lose money when inflation heats up, but they're unlikely to make much, either. It's pure fantasy to think that putting 10% or 20% of your assets in TIPS will insulate your portfolio against inflation. If you want real inflation insurance, you'll almost certainly do better with commodities, which I'll discuss shortly.

TIPS are pricey

TIPS have advanced smartly over the past six months as fears of deflation have abated. Year-to-date through June 11, ten-year Treasury notes have lost 11%, while 30-year bonds have tumbled 28%. TIPS, meanwhile, have risen about 5%. That means that TIPS, which deliver a real, before-inflation-adjusted yield of 1.9% on maturities of ten or so years, are no longer cheap relative to Treasuries, says Ken Volpert, head of taxable bonds at Vanguard. "TIPS are a lot richer than they were six months ago," he says. "I wouldn't sell them, but I don't think I'd buy them here." (I wrote a bullish piece on TIPS in January.)

Dan Shackelford, manager of T. Rowe Price New Income (symbol PRCIX), a taxable-bond fund, is even less optimistic. TIPS account for just 1.5% of the fund. "TIPS are a subset of the Treasury market," he cautions.

Consider the inner workings of one of the best TIPS funds, Vanguard Inflation-Protected Securities (VIPSX). The fund, a member of the Kiplinger 25, sports an average maturity of nine years and yields 1.5%. That's the return you can expect before inflation adjustments.

But if interest rates on Treasuries maturing in nine years were to rise by one percentage point over the course of the next year, the fund's price would drop by about 5.9%. If rates increased by two percentage points, the price would fall by 11.8%.

In the meantime, of course, you'd get the inflation adjustment. So suppose the CPI rises from zero to 3% over the next year, but interest rates also rise by one percentage point. You'd start with that 1.5% real yield and gain 3% from the inflation adjustment, but lose 5.9% because of the rise in yields. In sum, you'd be facing a loss of a bit more than 1%.

Don't get me wrong. Compared with regular Treasury bonds, TIPS are a no-brainer. Treasuries make little sense in today's market given Uncle Sam's growing borrowing needs. Unless you foresee a return to the near-Armageddon-like conditions of last fall and winter, with widespread concerns about deflation and defaults, buying a straight Treasury bond yielding less than 4% doesn't make sense.

Most bonds other than Treasuries have rallied sharply along with stocks since early March, but bond-land still offers better opportunities. You can get a 3.4% tax-exempt yield on Vanguard Intermediate-Term Tax-Exempt fund (VWITX) or a 5.6% taxable yield on Vanguard Intermediate-Term Investment Grade fund (VFICX), which invests in corporate bonds. The muni fund will lose about 6% in price if rates on munis with similar maturities rise one percentage point; the corporate fund will lose about 5%.

Where should you look for real inflation protection? I think you have to look at more-aggressive investments. The prices of oil and other commodities are likely to far outstrip overall inflation. Indeed, rising commodity prices as the economy begins to show signs of life may be the biggest driver of inflation. Consider a fund such as T. Rowe Price New Era (PRNEX), which invests in stocks of oil-and-gas companies, as well as a wide range of other commodities, including metals and fertilizer. Putting 5% to 10% of your stock money in a fund like this may serve you well as inflation heats up.

The nightmare scenario for many investors is that the flood of new Treasury obligations will cause interest rates to soar and the dollar to plunge. I don't think that's likely. But if it happens, TIPS won't save your investments from capsizing. A commodities fund, however, could be a life preserver.