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:

• ChristmasTraditions:
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• Web Site:
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• Money Morning Special Investment Report:
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• Money Morning Special Investment Report:
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• Wikipedia:
  Ebenezer Scrooge

Keith Fitz-Gerald

About the Author

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

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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