Fed's Moves Make TIPs a Better Bet

04/16/2009 12:00 pm EST

Focus: FUNDS

Tim Middleton, contributor to MSN Money, says inflation soon will be rearing its head, and Treasury inflation-protected securities (TIPs) are a good way to protect yourself.

"Quantitative easing" means the Federal Reserve intends to flood the market place with money, and it isn't acting alone. Central banks in Japan, Great Britain, China and Switzerland have announced the same goal.

[The] inevitable result is inflation, because easy money is hard to shut off. Inflation is toxic to bonds. But one type of bond is inoculated against inflation, and it is becoming the most sought-after bond of all.

Treasury inflation-protected securities, or TIPS, actually benefit from rising prices and will deliver outstanding results when inflation begins to heat up as global growth is restored. "We could easily see these double over the next 12 to 18 months," says John Brynjolfsson, the author of "Inflation-Protection Bonds" and the chief investment officer of Armored Wolf, a hedge fund in Aliso Viejo, Calif.

TIPS are easy to buy in mutual funds and exchange-traded funds (ETFs), and they are cheap. But savvy investors are beginning to buy them, and they're ahead 3.3% in the past month.

Brynjolfsson says the Fed is targeting an inflation rate of 4% to 6%, which it should hit within two years. However, he says, "I expect that goal will be overshot, with inflation heading to 10%, very possibly."
TIPS have a relatively low but certain yield—a "real return," which is why they are sometimes called real-return bonds—but their principal value is adjusted upward in line with the Consumer Price Index.

In a period of inflation, the upward revisions could be striking. At the same time, conventional Treasury bonds would be cratering. The only risk they have is interest-rate risk, and rates rise with inflation. Every one-point up tick in inflation could take their value down as much as 10%.

The best source of funds for purchasing TIPS, therefore, would be the sale of conventional Treasury bonds and Treasury bond funds. But other bonds also suffer when rates rise, so other sell candidates are high-quality bond funds in general.

Not that you need to rush. Moving in patient steps—every few months, if you're moving lump sums, or every payday, by switching new flows into a TIPS fund in your 401(k)—I would recommend cutting back diversified, high-quality bond funds and building up a TIPS allocation.

Some of the best are Vanguard Inflation-Protected Securities (VIPSX), T. Rowe Price Inflation Protected Bond Fund (PRIPX), and Harbor Real Return Institutional (HARRX), which is a no-load version of Pimco Real Return (PRTNX).

There is also an exchange traded fund, iShares Barclays TIPS Bond (NYSEArca: TIP)  [which] over the past five years has outperformed the average TIPS mutual fund by roughly one percentage point a year. That's largely the result of its exceptionally low 0.2% expense ratio.

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