If You Want to Use "TIPS" to Beat Inflation, Follow These Tips

Keith Fitz-Gerald

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

Many investors are worried about inflation and we're among them.

The data is downright scary. Not only are consumer prices rising faster than expected, but you have to keep in mind that the inflationary indicators that are spooking us are actually "lagging indicators" – meaning they're already several months old by the time we see them.

That means the inflation situation could actually be much worse than we currently believe. It means that prices at the supermarket, at the gas pump, at the pharmacy, at the shipyard import pier, and at the factory loading dock would well be out of control long before the Bush Administration, Congress and the U.S. Federal Reserve figure out what regular folks like you and I already know – that inflation is real and picking our pockets every day.

To keep this daily beating from becoming an irreversible rout, many investors are rushing to buy a security known as Treasury Inflated Protected Securities, or TIPS. These little wonders are issued by our favorite uncle – who happens to be named "Sam" – which is important to understand, since it means they are guaranteed against default.

TIPS have a simple purpose: They're intended to provide investors a way to hedge against inflation, because they're tied to the Consumer Price Index (CPI).

But there's a problem: If you study it closely, the CPI ends up being more cooked than the prize goose that Ebenezer Scrooge gave Bob Cratchit as a Christmas gift. And that suggests that TIPS aren't all they're supposed to be; investors who are piling in, now, are destined to be disappointed – especially when they may be locking themselves into yields that are pathetically low, if not negative, relative to inflation.

Here's why.

The U.S. government, itself, says that "official" TIPS yields are running near all time lows. As of Feb. 25, for instance, the yield on the 10-year bond is a measly 1.53%. Five- and seven-year bonds aren't any better, relatively speaking, with yields of only 0.71% and 1.19%, respectively.

In plain terms, that stinks. Investors who buy in at these levels are effectively stuck the moment they plunk down their money.

That's a major problem, to be sure. But there's an even bigger one, and very few investors are aware of it. The actual returns they obtain if they buy in now when bonds are trading at very high prices are likely to be even worse. Not only will transaction fees eat into the already-pathetic yields, but so will taxes if they hold their TIPS in taxable accounts – as most investors will likely make the mistake of doing.

Here's an example adapted from a recent Wall Street Journal report. Imagine that inflation spikes to 5% – neither an unreasonable nor unlikely assumption. Ten-year TIPS with a 1.53% yield will effectively pay 6.53%. At a 35% tax rate, that translates into a real return of 4.24%, which is obviously far below the real rate of inflation we feel in our wallets. That's also nearly equal to – but is still slightly below – the latest government data showing that inflation was running at a 4.3% annual rate.

In other words, the lower yields go as investors seek safety in TIPS, the worse real returns can get for the investors in higher tax brackets who pay a premium to buy them. They can even go negative.

Still, that's not so bad – particularly if you are bound and determined to protect your purchasing power when you consider the "break-even inflation rate." Right now 10-year Treasuries are yielding 3.96% against the 10-year TIPS yield of 1.53% that we just mentioned. That means that if inflation is higher than 2.43% [and there's a pretty good chance it will] per year for the next 10 years, TIPS will be a better investment than the equivalent Treasuries.

If you want to buy TIPS even at these high levels, there are fortunately a few solid choices, including the Vanguard Inflation Protected Securities Fund (VIPSX), which has logged a nice compound annual growth of 6.1% over the past five years, and the Harbor Real Return Institutional Fund (HARRX), which is managed by PIMCO and which produced a nice 11.4% last year.

News and Related Story Links:

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• Wikipedia:
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Keith Fitz-Gerald

About the Author

Browse Keith's articles | View Keith's research services

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean, and he's also the founding editor of Straight Line Profits, a service devoted to revealing the "dark side" of Wall Street... In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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