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Why Inflation-Protected Bonds Look Attractive

NEW YORK ( TheStreet) -- While most bonds have sunk into the red lately, Treasury Inflation-Protected Securities suffered particularly steep losses. This year, SPDR Barclays TIPS ETF (IPE) declined 6.7%, compared to a loss of 2.0% for the Barclays Capital U.S. Aggregate Bond index.

Now some analysts argue that the inflation securities have reached attractive levels. "TIPS are cheaper now than they have been in a long time," says Brett Wander, chief investment officer for fixed income of Charles Schwab Investment Management.

Like other bonds, TIPS pay fixed yields. In addition, the inflation securities offer special protection since their principal values rise along with the consumer price index. Say you put $10,000 into TIPS, and the CPI rises 2% in the first year. Your principal value will be $10,200.

In recent years, TIPS have taken investors on a rollercoaster ride. As markets recovered from the financial crisis, investors raced to purchase TIPS, fearing that Washington's stimulus programs would ignite inflation. All the buying pushed up prices, and yields sank sharply.

When bond prices rise, yields fall. By December 2012, the yields on 5-year TIPS dipped below -1%. So an investor who put $10,000 into TIPS was guaranteed to lose more than $100 of principal in the next five years if there was no inflation. Frightened investors were willing to accept the negative rates because TIPS seemed less risky than the alternatives.

As investors grew more confident this year, they began dumping Treasuries and taking on more risk. TIPS funds suffered outflows. With inflation muted, investors saw little reason to buy protection against rising prices.

When bond prices fall, yields rise. The yields on 10-year TIPS climbed from -0.65 in April to 0.28% now. At the current level, TIPS may not make anyone rich, but they can serve as effective insurance policies for savers seeking protection from inflation.

Analysts say that the inflation bonds look attractive compared to conventional Treasuries. Conventional 10-year Treasuries yield 2.28%. TIPS will outperform conventional Treasuries if the CPI rises more than 2.2% annually for the next decade. During the last century, the annual inflation rate was 2.8%. Analysts argue that inflation is likely to approach the historical average in coming years.
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