Invest in TIPS for Security, Not Income

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There are two reasons to own fixed-income securities: safety and income.

Today, yields are so low you might as well forget about income. But safety is always appealing, so it’s worth taking a look at TIPS, a type of U.S. government bond called a Treasury Inflation-Protected Security. Investors have been gobbling them up so fast the government has started issuing more, pushing the value of this market over $600 billion for the first time.

TIPS do have some downsides, but they offer a chance to conquer one of the biggest dangers to fixed-income investors — inflation. Today you could earn just more than 2% on a federally insured five-year certificate of deposit, according to the BankingMyWay.com survey, and your principal would be completely safe. But with inflation recently around 1.8%, you’d be earning almost nothing. And if inflation rose during the next five years, as seems likely given the economic recovery, you could lose money.

TIPS are designed to avert this problem by providing a yield guaranteed to exceed the inflation rate. Every six months, the value, or principal, of a TIPS bond is increased to reflect the past six months’ inflation. The coupon rate, or fixed interest rate paid by the bond, is applied against this ever-growing principal.

Currently, a 10-year TIPS yields about 1.3%. If inflation continued at about 2%, this bond would earn the equivalent of 3.3%. You could do a tad better with an ordinary 10-year Treasury bond, now yielding about 3.7%. But if inflation jumped to 5%, the ordinary bond would still pay 3.7% while the TIPS would earn 6.3%.

Like most bonds, TIPS are bought and sold in the secondary market after they are issued, and their prices and yields fluctuate according to supply and demand. If prevailing interest rates rise, investors won’t offer full price for older TIPS with lower yields, so the investor can lose money on a price decline. This may be partially offset by the semi-annual principal adjustments, since inflation and interest rates tend to rise together.

Also, you can hold a TIPS until it matures and the government pays you the bond’s full face value. That could mean living with a below-market interest rate for some time, though you’d still be protected against inflation.

As with ordinary Treasury bonds, interest earnings on TIPS are federally taxable, as are the semi-annual principal increases. Since those increases are not money in your pocket until you sell the bond or it matures, be sure to have cash available to pay taxes. Or buy TIPS through a tax-favored account like a 401(k) or IRA.

TIPS can be purchased with as little as $100 from the government through the Treasury Direct program. There also are a number of mutual funds that invest in TIPS, including Harbor Real Return Fund (Stock Quote: HARRX), Vanguard Inflation-Protected Securities Fund (Stock Quote: VIPSX) and Fidelity Inflation-Protected Bond Fund (Stock Quote: FINPX).

As with all mutual funds holding bonds, these funds do not have a maturity date, since they gradually change holdings to maintain an average time to maturity promised to shareholders. That means any of these funds could fall in value as market conditions change, and you might not be able to wait out the downturn as you could if you owned individual bonds.

This could be a problem as interest rates are more likely to rise than to fall, though the effect is less worrisome if you commit to the fund for the long term. In fact, that’s the basic rule for any TIPS investment: plan to hold it for five or 10 years. Because of price fluctuations, TIPS are not a substitute for a checking account.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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