Want A Hot Tip? Buy TIPS

Every portfolio needs inflation protection -- and the price is right

Convinced that inflation is no longer a threat, bond guru Bill Gross has been unloading his vast holdings (roughly $8 billion from his $86 billion PIMCO Total Return Fund, according to Morningstar) in Treasury Inflation-Indexed Securities (TIPS). Because Gross's Pacific Investment Management is one of the largest bond managers in the U.S., his decision helped trigger a sell-off in the TIPS market.

Now, other bond mavens say TIPS are a good deal -- even if Bill Gross is selling them. TIPS are designed to protect your principal against the ravages of inflation, something that traditional bonds do not provide. Since TIPS have this special attribute, they zig when other securities zag, adding diversification to your portfolio.


Why is Gross so down on TIPS? Pros like him are paid to beat the market, and they gravitate to the securities that they think will perform best before their next report to shareholders or clients. Individual investors, on the other hand, are beholden only to themselves, and are not so concerned with short-term performance. TIPS are a long-term play.

Here's how they work: Like conventional bonds, inflation-proof bonds pay interest twice a year. The interest rate is lower, now about 2% for 10-year TIPS, because the principal will adjust to offset any increase in inflation. But here's what makes them attractive now: The U.S. Treasury bond yields 4.3%, which is about 2.3 percentage points higher than the comparable TIPS yield. So if inflation goes above 2.3%, you will be better off having invested in the TIPS as opposed to the regular bonds.

Portfolio strategists say you should put 5% to 10% of your fixed-income allocation in TIPS. "TIPS should be part of every fixed-income portfolio," says Donald Ellenberger, a government bond manager at Federated Investors (FII ). They should also be held in a tax-deferred retirement account. That's because the inflation adjustment is taxable but doesn't give you any current income. You can buy new-issue TIPS directly from the U.S. Treasury Dept., through a broker, or even in a mutual fund. More than 20 fund companies, including Fidelity, T. Rowe Price (TROW ), and Vanguard offer TIPS funds.

Few in the bond market foresee a spike in inflation that would put TIPS at the top of the performance charts. Still, Daniel Dektar, chief investment officer at Smith Breeden, a fixed-income management firm, thinks there's room for them to shine. "The bond market usually is a little shortsighted on inflation," says Dektar. "It can't see anything too different from the recent past."

Even Gross acknowledges that TIPS have a place in a diversified portfolio. At an investment conference in June, he told attendees that TIPS offered "a decent piece of insurance protection in case we're wrong." Since the cost has fallen in recent weeks, now's a good time to buy that policy.

By Lauren Young

    Before it's here, it's on the Bloomberg Terminal.