NEW YORK (TheStreet) -- During the past 12 months, the consumer price index rose 3.6% and oil prices climbed. Seeking to benefit from rising prices, investors scrambled to buy Treasury Inflation-Protected Securities. Inflation-protected funds -- which invest in TIPS -- returned 8% in the past year, outpacing the Barclays Aggregate Bond Index by nearly 3 percentage points, according to Morningstar.Should you join the crowd and buy inflation funds? Perhaps. Many financial advisers argue that the inflation funds make good choices for investors who seek to protect their purchasing power. But now some advisers have become lukewarm about TIPS, arguing that they have gotten a bit expensive. A vocal minority says investors should avoid TIPS altogether. In some respects, TIPS resemble Treasury bonds. Like Treasuries, TIPS make fixed-interest payments that are guaranteed by the government. When interest rates rise, the prices of TIPS and Treasuries can fall. But TIPS are unique because the principal value rises along with inflation. If the CPI climbs 3%, then the principal value of TIPS will climb by that amount. During the past year, everything worked in favor of TIPS investors. Interest rates fell, and bond prices rose. In addition, the rising CPI boosted TIPS. But as TIPS prices rose, yields sank to near record lows. The yield on 10-year securities is a measly 0.58%. On five-year TIPS, the yield is -0.48%. The negative yield has occurred because the securities sell for a premium price of 102. So an investor must pay about $1,020 to buy a security that will only be worth $1,000 on maturity. Are investors guaranteed to lose money on five-year TIPs? Not necessarily. If you buy now, you will receive regular annual interest payments of 0.15%. That is not enough to compensate for the drop in value from 102 down to 100. But if the CPI rises, the principal of TIPS will rise, and investors could come out ahead. Say the CPI continues rising at 3.6% for the next five years, an outcome that is entirely possible. Then TIPS would outperform conventional Treasuries by a comfortable margin. "TIPs are expensive, but they can still provide value for long-term investors," says Peng Chen, president of Morningstar's global investment management division.
Chen figures that inflation will remain subdued for the next two or three years. If that occurs, then TIPS would deliver meager results. But for the longer term, it is difficult to predict what the inflation rate will be. If inflation spikes, TIPS could offer a sound way for investors to protect their purchasing power. To own TIPS, consider American Century Inflation Protection Bond ( APOIX) . The fund has returned 7.1% annually during the past five years, outdoing 82% of competitors. The fund must keep at least 80% of assets in inflation-protected bonds. But when TIPS seem expensive, the managers can shift some assets to conventional bonds. The fund currently has 11% of assets in corporate bonds. "Because of the low yields on TIPS, we believe that investment-grade corporate bonds offer better opportunities," says portfolio manager Robert Gahagan. Some managers urge investors to shun TIPS altogether. The doubters say that TIPS could produce meager returns in coming years or even slip into the red. Say inflation remains subdued and interest rates increase. Then the principal value of TIPS would rise along with the CPI, but the gains could be offset by the principal losses that all bonds suffer when interest rates rise. Such a scenario occurred in 2006, when interest rates rose. For the year, inflation funds barely broke even. Because of the uncertainties of the bond markets, TIPS don't necessary provide much protection against inflation, says Scott Wolle, Invesco's chief investment officer of global asset allocation. "TIPS don't necessarily reflect the higher costs that you see in the grocery store and gas station," he says. Instead of holding TIPS, investors should invest in commodities, Wolle argues. He says that in the past when inflation spiked, commodities typically rose too. Commodities should continue tracking inflation because higher prices are being driven by growing demand from emerging markets. Wolle is a member of the team that manages Invesco Balanced-Risk Allocation ( ABRZX), a fund that is designed to protect investors from inflation and other market hazards. Under normal circumstances the portfolio has one third of its assets in commodity futures. The managers figure that commodities will rise if inflation spikes.