TIPS: Inflation Protection For Your Portfolio

One of the most insidious threats to your ability to build wealth in the long run is inflation. Inflation is a reduction in your buying power that can make retirement a bit difficult. Keeping your money in a savings account — especially with the low yields we see now — might mean that inflation causes you to lose money sitting in the bank. The same is true of bonds when they have low yields. However, some investors are uncomfortable with relying too much on stocks to help them beat inflation. If you want to add a little more stability to your portfolio while keeping pace with inflation, TIPS might be a workable solution.

What Are TIPS?

Treasury inflation-protected securities (TIPS) are bonds offered by the U.S. government. They are designed to keep pace with inflation, since the principal is adjusted at regular intervals to reflect changes in the Consumer Price Index. The face value is adjusted according to the CPI, and the yield is paid on that higher principal. Realize, though, that deflation can mean that your TIPS principal might be adjusted downward (although never below what you paid).

Even with recent troubles, and talk of a possible credit downgrade, many still consider U.S. Treasuries the most reliable bonds in the world. The risk of default is always there, but it is generally considered a very low risk.

Things To Consider Before Investing In TIPS

Before you get excited about TIPS, you need to take a few things into consideration. They can work well in your portfolio, and provide you with peace of mind and some help beating inflation. But you need to keep a few things in mind about them:

• Yields are generally lower than other Treasuries: Because of the principal adjustment, TIPS have lower yields. There are some instances that — even with inflation in the equation — you can do better overall looking into higher yielding bonds.
• You pay income taxes on TIPS adjustments: If you have a net increase in your TIPS principal over the course of the year, you have to pay income taxes on that amount, at your marginal tax rate. You won't receive the cash payout until your bond matures, but you still have to pay taxes on the income. Many people like to hold TIPS in tax-deferred accounts for this reason.
• Treasury Direct doesn't provide TIPS for IRAs: One of the reasons that people like TIPS is that you can get them from Treasury Direct without paying fees and commissions. However, the government doesn't offer this service for IRAs and Roth IRAs. In order to add TIPS to your IRA, you have to go through a broker. Some brokers will let you add TIPS to your IRA fee-free — but only if you purchase a minimum amount.
• CPI might not accurately reflect your personal inflation rate: A debate among economists and others rages about whether CPI is a “good” measure of inflation. In any case, TIPS won't protect you in the event of rising interest rates in other areas of life, and CPI might not accurately measure your own personal rate of inflation. Take this into consideration as you determine whether or not TIPS are a good inflation hedge in your particular situation.

TIPS really can be a good addition to your portfolio. However, like all investments, you need to carefully consider how they would fit into your overall goals and financial plans.