Chen figures that inflation will remain subdued for the next two or three years. If that occurs, then TIPS would deliver meager results. But for the longer term, it is difficult to predict what the inflation rate will be. If inflation spikes, TIPS could offer a sound way for investors to protect their purchasing power.
To own TIPS, consider American Century Inflation Protection Bond (APOIX) . The fund has returned 7.1% annually during the past five years, outdoing 82% of competitors. The fund must keep at least 80% of assets in inflation-protected bonds. But when TIPS seem expensive, the managers can shift some assets to conventional bonds. The fund currently has 11% of assets in corporate bonds. "Because of the low yields on TIPS, we believe that investment-grade corporate bonds offer better opportunities," says portfolio manager Robert Gahagan.
Some managers urge investors to shun TIPS altogether. The doubters say that TIPS could produce meager returns in coming years or even slip into the red. Say inflation remains subdued and interest rates increase. Then the principal value of TIPS would rise along with the CPI, but the gains could be offset by the principal losses that all bonds suffer when interest rates rise. Such a scenario occurred in 2006, when interest rates rose. For the year, inflation funds barely broke even.
Because of the uncertainties of the bond markets, TIPS don't necessary provide much protection against inflation, says Scott Wolle, Invesco's chief investment officer of global asset allocation."TIPS don't necessarily reflect the higher costs that you see in the grocery store and gas station," he says. Instead of holding TIPS, investors should invest in commodities, Wolle argues. He says that in the past when inflation spiked, commodities typically rose too. Commodities should continue tracking inflation because higher prices are being driven by growing demand from emerging markets. Wolle is a member of the team that manages Invesco Balanced-Risk Allocation (ABRZX), a fund that is designed to protect investors from inflation and other market hazards. Under normal circumstances the portfolio has one third of its assets in commodity futures. The managers figure that commodities will rise if inflation spikes.