Have a Look at TIPs if Inflation Rears Its Head

With all the recent turbulence in the financial markets, many investors are reevaluating their portfolio mix. Hopefully, the Mideast summit will take some of the steam out of oil prices. However, oil is still up strongly year over year and we still face refining bottlenecks this winter. The latest Consumer Price Index is due Wednesday and forecasters are expecting energy costs to push it up. So if you're looking for a way to put relatively cheap inflation protection into your portfolio, it might be a good idea to take a look at a fairly new class of Treasury issues called TIPs, or Treasury Inflation Protected Securities.

TIPs aim to insulate their owners from inflation. They do this by adjusting the amount of principal paid out at maturity to reflect changes in the Consumer Price Index over the life of the bond. With the release of every month's inflation data, an adjustment is made to the principal value of the bond. Because of the adjustment process, they are much more complicated than regular Treasury issues. You can get the full details on the TIPs program from the Treasury's Web site.

Before you put these into your portfolio, you need to know their drawbacks. They are "back-end" loaded, meaning that much of the benefit from the inflation adjustments is not paid out until maturity. This feature will cause the price of TIPs to behave differently from similar maturity-coupon issues. If held in a taxable account, taxes are due on the inflation adjustment in the year they are credited, even though the benefit isn't paid until maturity. Although TIPs have the potential to deliver a higher total return than regular Treasuries, they have a lower current yield. These unique features mean that TIPs are best-suited for tax-sheltered accounts (like IRAs and 401(k)s) and for investors for whom current income is not a priority.

Partly due to their complexity, TIPs have not become as wildly popular with investors as the Treasury had hoped when the program was announced in 1996. Back then, the government was running a $100 billion deficit, and these new issues were viewed as a way for the Treasury to diversify its funding methods. With the advent of budget surpluses, TIPs auctions have been less frequent and of smaller size than initially hoped. This means that the TIPs market has not yet been able to develop into a very large or liquid one.

Some big institutional investors have found that they can't buy enough TIPs to make a difference to their portfolios without owning too much of an outstanding issue's "float." TIPs are also not candidates to be bought back by the Treasury, so their prices have not benefited from the demand seen by their fixed-coupon counterparts this year. The good inflation performance of the last few years and the Fed's determination not to let price hikes get out of hand have also taken away some incentive for many investors to protect themselves from rising prices.

The lack of investor interest could be a reason TIPs may currently offer good value. A way to measure the attractiveness of TIPs is to compare them to regular Treasuries. Subtracting the yield on TIPs from the yield on traditional issues produces what is called the "break-even" inflation rate. TIPs will outperform comparable fixed-coupon issues if the Consumer Price Index runs above this break-even rate each year over the life of the bond. A look at current levels shows that TIPs will do well unless inflation returns to very low levels:

A Pretty Good TIP Treasury Inflation Protected Securities offer good value
Maturity	Traditional Coupon Treasury Yield	TIPs Yield	Breakeven Inflation Rate
5 years	5.71%	3.59%	2.16%
10 years	5.74%	3.92%	1.82%
30 years	5.81%	3.91%	1.90%

It's difficult to predict any economic variable one year into the future, let alone five, 10 or 30 years. But contrast the above break-even inflation rates with some well-known forecasts. The Philadelphia Fed's third-quarter survey of economists came in with a 12-month inflation forecast of 2.7%; this quarter's prediction should come in higher after this fall's run-up in oil prices. The University of Michigan's survey of consumers' future inflation expectations is currently running at 3.0%.

The gap between the break-even inflation rate and forecasts is fairly large and could be signaling that this is a good time to own TIPs. If the Consumer Price Index climbs 3% this year, then a five-year TIP will outperform its regular Treasury counterpart unless the CPI falls to well below 2% for the rest of the life of the bond. While it's possible that oil prices could plummet and take the CPI down to that level for a time, there have been only two multiyear stretches of sub-2% inflation in the past 50 years. If Gerald Jordan's outlook for energy is even only partly fulfilled, TIPs could prove to be a valuable addition to a portfolio.

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Brian Reynolds is a certified financial analyst with more than 16 years experience as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at [e-mail].