Hot TIP for ETF Investors

"Rising interest rates are typically characterized by rising inflation and the protection offered through TIP through higher dividends should enable the performance of TIP to compare favorably," says Mazzilli, who cautions investors that the TIP could also decline if long-term interest rates rise.

Long-term interest rates have been expected to rise since early 2004, as the Fed embarked on its campaign of measured rate increases. Nevertheless, apart from a spike in the spring of 2004, the yield on the benchmark 10-year Treasury bond has stayed 4% and 4.3% since the beginning of 2004. Yields rise as bond prices fall, and vice versa.

Investor awareness in TIPS has grown substantially over the past year as financial advisers have increasingly attempted to prepare their clients for a potential spike in inflation. The increased interest in TIPS has led many analysts, including Mazzilli, to note that the inflation-fighting bonds might potentially be overvalued; this would be a negative for investors interested in diving into the TIP market now.

"While valuations have improved recently, our interest rate strategists believe 10-year TIPS remain slightly expensive," says Mazzilli. "As of Jan. 6, the implied break-even rate of inflation was 255 basis points for the 10-year TIPS, which is above our current inflation forecast."

The difference between comparable maturity Treasury and TIPS yields is viewed as the break-even inflation rate.

Despite concerns about overvaluation, Mazzilli notes that the TIP can be useful for investors who wish to maintain a position in inflation protected securities without going to the expense of buying individual TIP bonds.

"Buying individual bonds can be quite expensive for investors," says Mazzilli. "And it is often difficult to build and maintain a diversified portfolio of bonds unless considerable resources are allocated to the asset class."