Could you do a piece on TIPS? I was interested until I ran into this article. -- Bob Dunne

Bob,

If that article, which appeared in the

Dallas Morning News

on Dec. 1, 1996, kept you from buying TIPS, or Treasury inflation-protected securities, in the last year, that's unfortunate.

Because if you'd had money in a TIPS mutual fund this year, your total return through June 30 would have been something on the order of 2.91% vs. a loss of 4.75% in a regular Treasury bond fund. Those are averages for inflation-indexed funds and general U.S. Treasury funds (excluding institutional funds), according to

Lipper

.

Scott Burns, author of the article you read, argues that TIPS don't make sense unless held in a tax-deferred account. That's not necessarily the case, and I'll tell you why. But first some background.

TIPS, readers may recall, are Treasury notes and bonds whose principal is indexed to the

consumer price index

.

With regular Treasury securities, the investor receives interest on principal of $1,000 at the rate stated by the bond's coupon. The principal never changes, and the yield is based on how much investors expect future inflation to erode the value of their interest payments and principal repayment.

You may have heard people distinguish between nominal yields and real yields. Yields quoted for regular Treasuries are nominal yields. Real yields are what's left over when you subtract the current annual rate of inflation -- 2% in June -- from nominal yields. They represent the securities' after-inflation value to the investor.

TIPS, theoretically, pay the investor a real yield. They carry smaller coupons than standard Treasuries, but coupon payments are calculated on principal that grows in line with CPI inflation. The investor concern when buying TIPS is not future inflation but how the yields compare to the real yields on standard Treasuries.

For example, according to the institutional price quotes in

The Wall Street Journal

from Thursday, the most recently issued 10-year TIPS issue, with a 3.875% coupon and accrued principal of $1,013, yielded 4.02%. That compares with a 5.78% yield on the most recently issued standard 10-year Treasury, which carries a 5.5% coupon. Less 2% CPI inflation, the real yield on the standard Treasury is 3.78%. So, at the moment, TIPS offer only a 24-basis-point advantage over regular Treasuries. As recently as the beginning of this year, however, the advantage was closer to 70 basis points.

TIPS have outperformed standard Treasuries this year to such a large degree because, while nominal yields have risen, real yields have held fairly steady.

TIPS and Taxes

So what's Scott Burns' beef with TIPS? It's that investors who hold TIPS in taxable accounts (as opposed to tax-deferred accounts) owe tax each year not just on the coupon income they receive, but also on the accrued principal, which they do not receive until the bond matures. Having to pay tax on income you don't receive in the same year raises your effective tax rate, he argues.

There's a logic to his argument, but it's a narrow-minded logic, particularly if you're considering investing in TIPS through mutual funds, explains John Brynjolfsson, manager of

(PRRIX) - Get Report

Pimco Real Return Bond. Pimco Real Return Bond is the best-performing fund of all U.S. Treasury and U.S. government bond funds this year, beating the next-best performer by more than 1.5 percentage points, according to Lipper. Brynjolfsson has co-authored or co-edited a couple of books on TIPS.

TIPS offer two clear advantages over regular Treasuries, he points out. First, interest is paid every six months on the full amount of principal that has accrued on the payment date. Standard practice would be to calculate interest each day based on the amount that had accrued until that date, which would yield a smaller payment. "The difference isn't large, but it's worth a couple of basis points, particularly in higher-inflation environments," Brynjolfsson says, adding that this feature makes TIPS "unlike any financial instrument I've ever heard of."

The second advantage, he says, is that TIPS are a lower-risk investment than regular Treasuries, and that allows investors to be more aggressive in the rest of their portfolios.

Weighing TIPS vs. Treasuries

Based on these advantages, an investor choosing between standard Treasuries and TIPS should prefer TIPS. Should the tax issue be a deal-breaker for investors planning to hold the securities in taxable accounts? Brynjolfsson says no, particularly if you intend to reinvest all or even a portion of your earnings. Investors who would spend every cent of the cash flow from regular Treasuries are the only ones who should think twice.

Consider this example: An investor in a standard Treasury with a 6% coupon and an investor in a TIPS with a 3% coupon, with inflation running at 3%, a year would have identical tax bills. But the first investor would have received $60 of coupon income, while the TIPS investor would have received something over $30, with the balance to be paid as accrued principal upon maturity.

"The question becomes: What are you going to do with the cash flow?" Brynjolfsson says. "If you need it, you're going to spend it. But if you didn't need it, you'd reinvest it."

If you own regular Treasuries through a mutual fund, reinvestment is a fairly simple process. But if you own individual bonds, reinvestment is complicated and there are costs involved. Inflation-indexed bonds, by contrast, effectively reinvest a portion of your income for you, at no cost.

The issue is even simpler for investors who own TIPS through mutual funds, who can easily spend their accrued principal if that is what they wish to do, since mutual funds are required to distribute it annually.

Holders of individual TIPS who require more spending money than the coupons generate are admittedly in a relatively tough position. To spend accrued principal, they'd have to sell, and the TIPS market is illiquid compared to the regular Treasury market.

Still, as any investor in a TIPS fund this year will tell you, the idea that TIPS are a bad investment for everyone is patently false.

Send your questions and comments, along with your full name, to

fixed-incomeforum@thestreet.com.

TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.