NEW YORK (

TheStreet

) -- After being clobbered in the turmoil of 2008, inflation-protected bond mutual funds have recovered smartly.

During the past year, these funds have returned 8.4%, outpacing the Barclays Capital Aggregate Bond index by half a percentage point, according to Morningstar.

But after the recent rally, TIPS are hardly bargains. Chances are the inflation-protected funds will produce only modest results for the next year or so.

The funds invest mainly in Treasury Inflation-Protected Securities (TIPS). Because TIPS can prevent portfolios from being eroded by inflation, many financial advisers recommend holding inflation-protected funds for the long term.

To appreciate why the outlook is subdued, consider that TIPS deliver returns in two ways. Like all bonds, TIPS pay interest income. In addition, the principal of the inflation securities rises along with the consumer price index. Say you put $1,000 into TIPS, and inflation rises by 3%. At the end of the first year, your principal would be $1,030.

Recently, 5-year TIPS were issued with annual interest income of 0.50%. But with investors fleeing to Treasury securities of all kinds, the prices of TIPS have risen sharply. Bonds that were issued at a price of 100 now sell for 104.5. That price is steep. If inflation is flat, you will only receive back 100 in principal on the maturity date. Because of the potential principal loss, the current annual yield is listed as -0.46%.

Why would anyone buy an investment that seems poised to deliver a loss? Some investors believe that inflation will rise sharply. If that happens, then the principal value of TIPS will climb, and the return could be positive. Say inflation climbs at an annual rate of 1.71% for the next five years. The TIPS would deliver about the same total return as conventional 5-year Treasuries, which currently yield 1.25%. If inflation runs higher -- as some economists expect -- then the TIPS would outdo conventional Treasuries.

No matter what your outlook on future inflation, you may want to put a small portion of your assets in TIPS. The securities can help to diversify a portfolio because their value may hold up during periods of inflation. But keep in mind that yields of TIPS are normally lower than the yields on conventional Treasuries, and TIPS can lag returns from corporate bonds.

"Think of TIPS as an insurance policy," says Roger Early, portfolio manager of

Delaware Inflation Protected Bond

(DIPAX)

. "You may have to give up some income in order to obtain the protection."

You can buy TIPS directly from the U.S. Treasury. But many investors may prefer holding a fund. Top portfolio managers can limit losses in downturns and outdo the benchmarks over the long term. A strong performer is the

BlackRock Inflation Protected Bond

(BPRAX) - Get Report

, which returned 6.6% annually during the past five years, outdoing 93% of its competitors. During the downturn of 2008, BlackRock eked out a small return, a strong showing in a year when the average inflation-protected bond fund lost 4.1%.

BlackRock portfolio manager Brian Weinstein stayed afloat by selling some TIPS and shifting nearly 20% of his assets into cash. When markets began to recover, Weinstein started buying depressed TIPS and scored sizable gains. These days, he is fully invested, figuring that inflation will rise in the future and boost TIPS returns. "The

Fed

has said that they hope to create inflation, and I don't doubt that they will try," he says.

Another solid choice is Delaware Inflation Protected Bond, which has returned 6.2% annually during the past five years, outdoing 82% of competitors.

Portfolio manager Roger Early must keep at least 80% of assets in TIPS. With corporate bonds depressed in early 2009, he began buying issues with yields of more than 8%. Those rallied and helped to boost returns. These days he is buying inflation-protected bonds from commodity countries, including Australia and Brazil. Because inflation rates are rising in the foreign markets, the principal values of the bonds should climb.

Like all bonds, TIPS suffer when interest rates rise. To limit risk, Early is focusing on TIPS with maturities of 10 years or less. If rates rise, the shorter issues should prove more resilient than longer-dated securities.

--Written by Stan Luxenberg in New York.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.