TIPS Stay One Step Ahead of Inflation

Physician's Money Digest, March15 2003, Volume 10, Issue 5

Just as ocean waves erode theshoreline, inflation likewisewears away the purchasingpower of your investments. But USTreasury Inflation-Protected Securities(TIPS)—a relatively newinvestment choice—offset the effectsof inflation and, at the sametime, boast attractive yields.

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Available since 1997, TIPS canprovide physician-investors withconsistent protection against inflation.These bonds are guaranteed bythe US government to offer semiannualpayments that rise along withthe rate of inflation. TIPS aretoday's best bond buy, declares anarticle in .

COMPARING SECURITIES

Finance professors in the academiccommunity, with a good trackrecord for accurate predictions, aresinging the praises of TIPS. Theadmiration has much to do with theinflation protection inherent in thesesecurities. Other investment vehiclesaren't as reliable. Consider commonstocks, for example. A portfolioinvested in the S&P 500 lost 20%of its purchasing power from 1966to 1982. Traditional fixed-couponbonds performed even worse duringthis inflationary period. Other assets—such as real estate, collectibles,and gold—have also failed toshield against inflation.

In addition to inflation insurance,TIPS also offer a decent rate ofreturn. These bonds currently payapproximately 2.5% a year, whichwill grow along with the rate of inflation.If the consumer price indexrises by 2% over the next 12 months,then a $1000 investment in TIPSwould be revalued at $1020 ($1000times 1.02). The second year's totalpayout would be $25.71. However,without the 2% inflation adjustment,the same $1000 investment wouldmean only $25 in earnings. That maynot seem like a great deal after 1year, but if your investment wasconsiderably larger than $1000 andyou invested long term, the differencecan add up.

Sure, you can buy a fixed-couponUS Treasury bond thatyields a more appealing 4%. However,payout on such an investmentdoes not take inflation into account.Assuming the consumerprice index does, in fact, grow by2% over the next 12 months, theninflation will have eaten away halfthat bond's profit (leaving only 2%for the investor, which is less thanwhat the TIPS returned).

But if TIPS perform exceptionallywell during inflationary periods,then how do they fare in times ofdeflation? While deflation will temporarilyshrink their principal value,TIPS are required to pay at least theamount of their original issuanceprice when they mature. Indeed,TIPS are likely to out-gain commonstocks, real estate, and probablyeven cash during such times.

TIPS also tend to have slightlyless price volatility than a traditionalUS Treasury bond of the samematurity. This advantage comes inhandy if you need to sell a bondbefore it matures.

PROS AND CONS

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Another advantage is that TIPSdo not always behave like other USTreasuries with regard to interestrates. Holders of traditional bondsare fearful that the Federal Reservewill raise interest rates from theircurrent record-low levels (bondprices fall as interest rates climb).That's not likely to happen in thenear future, though, because theFed raises rates when inflation isaccelerating. The articlenotes, however, that if the FederalReserve was to raise interest ratesduring a time of rising inflation,TIPS would fare much better thantraditional bonds due to their inflationprotection feature.

On the negative side, tax lawsrequire that both the cash paymentof TIPS and the increase in theirprincipal value be treated as ordinaryincome. This means you willbe paying taxes on some gains thathaven't yet been received. You canavoid this negative feature by holdingTIPS in a tax-deferred account.

One other bit of bad news:

Thecurrent rate of return of 2.5% contrastsunfavorably with the higherrates these bonds offered a fewyears ago. In mid-1998, for example,TIPS briefly offered yields inexcess of 4%.

Should you decide to purchaseTIPS, the best approach would bethrough your broker or through theUS Treasury (800-722-2678; www.treasurydirect.gov). By doing so, youwill avoid the fees incurred if youwere to go though a mutual fund.

So, if you're looking for aninvestment windfall, TIPS are probablynot for you. But if you're concernedthat inflation's tide mightwash away a chunk of your investment,consider TIPS to be a viablealternative.