Investors who are worried about inflation should count on their TIPS, but new buyers of Treasury inflation protected securities shouldn't bet on the outsize returns of the past several years, and should avoid the temptation to use them as an interest rate hedge.

After a lengthy stretch of interest rate cuts, the latest consumer price index figures are starting to raise concerns about rising inflation, which will likely be accompanied by higher interest rates. Mindful of this possibility, investment advisers say they are putting more clients into funds that are based on TIPS, principal-adjusted securities whose value changes as the main consumer price index gauge shifts.

"That's the next bus coming down," says Jason Yaeger, a financial planner in Medford, Ore., who says he has adopted TIPS funds as his principal inflationary hedge. "If they aren't on it, a lot of people are going to get hurt."

Since their introduction in 1997, the securities, now issued as 10-year notes, have quickly filled the niche for which they were designed, says Carl Godwin, a financial planner in the Kansas City suburb of Chesterfield.

"I don't know that there has even been any great unanimity on how to deal with inflation," he says. "Financial assets have traditionally not done well in inflationary periods, and people sometimes purchase gold and real estate. TIPS are a relatively new thing. I use them in my portfolios, and I think they make good sense."

TIPS pay out fixed coupon rates, and the value of the principal is adjusted upward when inflation rises. A $1,000 investment paying 2% annual interest would rise in value if the consumer price index went up. So after a year in which inflation ran to, say, 3%, the original $1,000 would become $1,030. The interest payment would be $20.60. A year later, if inflation rises to the 4% level that the U.S. has averaged over the past 50 years, the principal would grow to $1,071.20, and the interest payment would be $21.42. (If deflation occurs, investors get back the face value of the principal.)

There are now about 20 mutual funds based on these securities, with a handful of new offerings in the works, and they are seen as the potentially least volatile hedge against inflation.

If predictions on inflation -- which was only 1.9% last year -- are on the money, TIPS are a smart bet, says John Hollyer, portfolio manager of the Vanguard Inflation-Protected Securities Fund. ( VIPSX ) The $4.9 billion fund has a three-year return of 10.37%, a bit above the average return of funds tracked by Lipper of 10.07% for the period.

"The most important reason for people to buy TIPS is if they genuinely need protection from inflation, because the returns of TIPS tend not to be all that well correlated to other types of bonds," he says.

Since the securities' first issue in 1997, the TIPS market has grown to about $200 billion. Five of the oldest TIPS mutual funds tracked by Lipper had an average three-year return of 10.07%.

But the growth of the market has some advisers concerned that TIPS are morphing a bit, and that new investors should not expect that sort of performance, even if coupon payments rise with increased inflation.

"Many people -- and it is human nature -- project past experience into the future," Hollyer says. "There's this thinking that TIPS can't lose. I think that's erroneous. I think it's probably fair value now, as opposed to attractive value."

Martin Vostry, a research analyst with Lipper, says high demand for the securities may start squeezing the performance of TIPS funds.

"At this point, the high demand right now and not as much supply, means prices have been driven up, and so yields have been going down," he says. "But over the longer term, TIPS funds are pricing in inflation at 2.3% for the next 10 years. If inflation behaves as it has historically, that still provides a good deal for investors."

Scott Berry, an analyst at Morningstar, says his worry over TIPS is that they lose sight of the main reason for their investments.

"The problem investors could have is that they're looking at TIPS as a defense against interest rates, instead of inflation," he says. "Given that yields are low and interest rates could move higher, I think they should have a more reasonable expectation."

They now have a few more options in terms of meeting those expectations. In December, Barclays Global Investors launched its iShares Lehman TIPS Bond Fund ( TIP), an exchange-traded fund that is cheaper than its actively managed competitors, charging 0.2% for its passive management, vs. Pimco's 0.47% annual fee.

Despite its parent company's recent spate of bad publicity, most investment advisers recommended the Pimco Real Return Fund ( PRTNX) as their first choice for a TIPS investment. The fund has a range of share classes and has both a retail and institutional clientele. Its Class A shares had a three-year return of 7.06%.

Yaeger, in Medford, says a comparison of the TIPS fund with Pimco's Total Return Bond Fund shows the TIPS fund is less volatile. As market interest rates rose last summer with investors convinced that the Fed's interest rate cutting days were over, shares in the Pimco fund dropped from a June 13 high of $11.66 to an Aug. 1 low of $10.54 -- a 9.6% decline. Shares in the TIPS fund went from $11.99 to $11.11 in the same period for a decline of 7.3%.

"It held up better because there is just more security associated with TIPS," Yaeger said. "Can you imagine how it will behave when inflation does show up? That's going to be a good indicator of how they are going to act when we start this upward interest rate march."

That disparity is a TIPS fund's best selling point, says Vanguard manager Hollyer.

As originally published, this story contained an error. Please see Corrections and Clarifications.

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