Inflation has been hurting bond prices this year, but inflation-protected bonds have gone down in price, too. What's the deal? It turns out that while Treasury Inflation-Protected Securities (TIPS) get added payments to compensate for inflation, that cash comes only when the bonds mature. In the meantime, they pay less interest than ordinary Treasuries.
Even so, financial advisers recommend that investors put a portion of long-term savings into inflation-protected securities. Despite short-term price swings, they are the only investment guaranteed to beat inflation over the long term. They're also one of the only asset classes, along with commodities, that tend to move in the opposite direction of the U.S. stock market. Owning TIPS for diversification can thus improve your portfolio's returns and dampen volatility.
This protection comes in a variety of instruments. The U.S. Treasury sells TIPS in 5-, 10-, or 20-year maturities directly to investors through treasurydirect.gov. The Treasury also sells "I bonds" that accrue interest and an inflation adjustments for up to 30 years. As they do with ordinary savings bonds, investors receive the accumulated interest when they choose to redeem.
There are TIPS mutual funds, too, but investors bear management fees which run, on average, about 1%. Since pricing anomalies do crop up, "a good manager should be able to outperform through bond trading even after expenses," says Jonathan Satovsky, a senior planner at Ameriprise Financial (AMP ) in New York. But funds can lose money, too -- in fact, TIPS funds lost, on average, about 2% in the first six months of the year. And unlike the securities they buy, the funds never mature and thus can't guarantee they'll beat inflation.
The vehicle you choose may depend on your tax situation. Investors owe taxes every year on both the interest they get from TIPS and the accrued inflation adjustment that won't be paid until maturity. In a tax-deferred account, that's not a problem. But I-bonds are the only taxable-savings product that lets investors defer all taxes until they redeem the bonds. Beat inflation and hold off the taxman? Not a bad deal.
By Aaron Pressman