TIPS' Time May Be Near

Investors who are worried about inflation should count on their TIPS, but new buyers of Treasury inflation protected securities shouldn't bet on the outsize returns of the past several years, and should avoid the temptation to use them as an interest rate hedge.

After a lengthy stretch of interest rate cuts, the latest consumer price index figures are starting to raise concerns about rising inflation, which will likely be accompanied by higher interest rates. Mindful of this possibility, investment advisers say they are putting more clients into funds that are based on TIPS, principal-adjusted securities whose value changes as the main consumer price index gauge shifts.

"That's the next bus coming down," says Jason Yaeger, a financial planner in Medford, Ore., who says he has adopted TIPS funds as his principal inflationary hedge. "If they aren't on it, a lot of people are going to get hurt."

Since their introduction in 1997, the securities, now issued as 10-year notes, have quickly filled the niche for which they were designed, says Carl Godwin, a financial planner in the Kansas City suburb of Chesterfield.

"I don't know that there has even been any great unanimity on how to deal with inflation," he says. "Financial assets have traditionally not done well in inflationary periods, and people sometimes purchase gold and real estate. TIPS are a relatively new thing. I use them in my portfolios, and I think they make good sense."

TIPS pay out fixed coupon rates, and the value of the principal is adjusted upward when inflation rises. A $1,000 investment paying 2% annual interest would rise in value if the consumer price index went up. So after a year in which inflation ran to, say, 3%, the original $1,000 would become $1,030. The interest payment would be $20.60. A year later, if inflation rises to the 4% level that the U.S. has averaged over the past 50 years, the principal would grow to $1,071.20, and the interest payment would be $21.42. (If deflation occurs, investors get back the face value of the principal.)