The Federal Reserve last week said it would buy $300 billion in long-term government bonds and $750 billion in mortgage-backed securities to help resolve the financial crisis. These actions will expand the money supply, which may lead to faster inflation. A weak economy and higher prices is a bad combination.

As we stare down the barrel of this threat, it makes sense to add inflation protection to a diversified portfolio with Treasury Inflation-Protected Securities, or TIPS. There are two exchange traded funds and mutual funds that provide access to TIPS.

The biggest difference between the funds and the actual bonds is that the bonds typically have a lower yield than traditional Treasury issues and the par value increases or decreases by the rate of change in the consumer price index (CPI). The funds typically pay out the CPI adjustments as part of the dividend.

The iShares Barclays TIPS Bond Fund ( TIP) and the SPDR Barclays Capital TIPS ETF ( IPE) are the two ETFs. They share the same benchmark. TIP, an older issue, has about 20 times the average daily volume of IPE.

Most mutual fund families and bigger discount brokerage firms have TIPS funds. Here are some:

  • Vanguard Inflation Protected Securities Fund (VIPSX)
  • Schwab Inflation Protected Investor Shares (SWRIX)
  • Fidelity Inflation Protected Bond Fund (FINPX)

The Vanguard fund is the cheapest of the traditional mutual funds, with a 0.20% fee. It hasn't paid a capital gain in the past few years. TIP and IPE haven't either.

There is an important thing to understand: The funds might not pay a dividend, depending on the CPI. For example, Yahoo Finance will tell you that TIP yields 5.89%. That isn't what you will get -- that number is based on the past year's dividends. Over the next year, the yield will be more or less, but to give you some idea of what to expect, TIP hasn't paid a dividend since October 2008.

The decision to buy now shouldn't come down to the current yield, but to your expectations about the consequences of the Fed's actions and what it could do to prices and, by extension, the other fixed-income instruments in your portfolio. For years, we have been living with a manageable rate of inflation, but that may change soon. As for me, for most clients, I allocate 15% to 20% of the fixed-income portion of their portfolio with iShares Barclays TIPS Bond Fund.

At the time of publication, TIP was a client holding.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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