Circle the Wagons Around Your Portfolio

,
Physician's Money Digest, July 2005, Volume 12, Issue 10

The Federal Reserve continues toraise interest rates. This trend ismost likely to continue throughout2005 and much of 2006,which will spell trouble for holders ofbonds with mid to long maturities. Thus,you might want to consider buying Treasuryinflation protected securities (TIPS).

As with regular Treasury bonds,TIPS pay interest semiannually, but yourinterest payments and your redemptionvalue at maturity are based on inflation.If inflation rises every year that you ownyour TIPS bond, your interest paymentsand your value at maturity will also rise.Because of this feature, the comparableinterest rate paid on a TIPS bond islower than a regular Treasury bond.Currently, the difference is approximately2.6%. This means that you shouldbuy TIPS instead of regular Treasurybonds if you expect inflation to rise morethan 2.6% for the term of the bond youare purchasing. In the unlikely event thatthere is deflation during your holdingperiod, you are guaranteed that theredemption value at maturity will neverbe less than par, but your interest paymentswould decrease.

TIPS can be purchased in 5-, 10-, and20-year maturities and may be purchaseddirectly from the Treasury Department(www.treasurydirect.gov) or through abrokerage firm. TIPS owners pay federalincome tax on interest payments in the yearthey are received and on growth in principalin the year that it occurs. The increasesin value due to principal adjustments createwhat is called "phantom income."In otherwords, you owe taxes on money thatyou did not receive. Therefore, TIPSbonds may be most appropriate whenheld in your retirement account.

One of the newest ways to get involvedin the TIPS marketplace is through anexchange traded fund (ETF). With an ETF,you are actually buying a basket of perpetuallychanging TIPS, much like a bondfund. Due to special rules for ETF TIPS,the principal adjustments are distributedmonthly along with the interest payments,so the phantom income problem is eliminated.For more information on ETFTIPS, visit www.ishares.com and look upthe symbol TIP. If you prefer a mutualfund, consider Vanguard's inflation protectedsecurities fund (www.vanguard.com; symbol VIPSX). In 2004, it produceda respectable total return of 8.3%and charged an investor-friendly 0.18%management fee.

is the founder

of the Welch Group, LLC, which

specializes in providing fee-only

wealth management services to

affluent retirees and health care professionals

throughout the United

States. He is the coauthor of J.K. Lasser's New

Rules for Estate and Tax Planning (John Wiley &

Sons, Inc; 2001). He welcomes questions or comments

at 800-709-7100 or visit www.welchgroup.com. This article was reprinted with permission

from the Birmingham Post Herald.

Stewart H. Welch III