One Way To Fight Inflation

In January 1997, the U.S. government began issuing a new type of bond: Treasury Inflation Protected Securities (TIPS). TIPS are a separate asset class that’s distinct from bonds because they behave differently during inflationary times. By owning them, you are further diversifying your portfolio and reducing risk. If you don’t own TIPS, you should. At MarketRiders, every retirement portfolio we recommend has at least a 5 percent allocation to TIPS.

Here’s why: Regular bonds depreciate in value if there is inflation. If you bought a $100,000 bond that pays 5 percent interest, you’d get your $5,000 per year in interest. But if in three years, bonds were paying 8 percent interest, the bond you owned would be worth less because investors would only have to buy a $62,500 bond to get the same $5,000 yearly payment.

TIPS protect you from inflation because the amount you get at maturity is adjusted for any inflation that occurred while you owned it. Think of TIPS as a bet with the government. If there is inflation, the government will take the Consumer Price Index and add that to the value of your bond. The coupon interest rate is constant, but it generates a different amount of interest when multiplied by the inflation-adjusted principal, which is how you are protected against inflation. Of course, if there is deflation, then your principal is reduced, but this is a rare economic circumstance. TIPS are offered in five-, 10-, and 30-year maturities.

Here’s how TIPS have performed so far: During the past five years, while there has been little to no inflation, TIPS have appreciated about 5.2 percent per year compared with an index of the total bond market which has returned 6.3 percent. But had there been rampant inflation during the past five years, you’d have been happier owning TIPS.

ETFs are the best way to own TIPS. You don’t have the hassle and cost of buying mutual funds, you can invest any amount that you wish, and you can buy shares for the cost of buying any stock through your online broker. Some investors go through the cumbersome process of purchasing TIPS directly from the U.S. Treasury, but your selection is limited. Other investors flock to such funds as BlackRock’s Inflation Protected Bond, for which they pay 1.63 percent in fees-more than the interest paid on the bonds themselves! Almost all funds that invest in TIPS hold about 30 to 33 bonds with a similar average duration of five years.

We’re all worried about QE2, government spending, and the diminishing value of our money when inflation kicks in. MarketRiders portfolios give you a bet with the U.S. government so that it can pay you for inflation.