Some Profitable TIPS
As energy prices plummet, it's easy to forget how badly even a little inflation can sap long-term returns and undermine otherwise sound investment portfolios. But advisers say that times like these are exactly when investors should buttress their nest eggs against future spikes in prices.
"Everybody should have at least some" investments guaranteed to beat inflation, says Paul Zhao, who runs Fischer Francis Trees & Watts's US Inflation-Indexed Portfolio. Among the best inflation hedges right now: the federal government's treasury inflation-protected securities, which are currently paying 2.43 percentage points above the consumer price index. "TIPS are a fantastic buy right now," Zhao says.
TIPS are less popular than standard fixed-rate treasury bills. But they can be more profitable, research by mutual fund giant Vanguard shows. They counterbalance the swings of the stock market, and on a risk-adjusted basis, TIPS can be as much as half again more profitable than comparable T-bills.
Investors interested in protecting their portfolios with safe, though not always spectacular, guaranteed real returns have four main choices:
I bonds. Small investors using the Treasurydirect.gov website can buy electronic inflation-protected savings bonds for as little as $25. (The smallest paper I bond sold through banks is $50.) I bonds now on sale earn 1.4 percentage points more than the consumer price index. They cannot be traded and cannot fall in value. I bonds pay off only when redeemed, and there are penalties for early redemption. Besides being exempt from state and local taxes, I bonds allow investors to defer federal taxes until redemption. And if the I bonds are cashed to pay qualified education expenses, they are completely tax exempt. Mel Lindauer, coauthor of The Bogleheads' Guide to Investing, says those tax advantages are worth only three quarters of a percentage point to average investors, however.
TIPS. The federal government auctions off TIPS, with terms from five to 30 years, at least once a quarter. TIPS are sold in multiples of $1,000 without commission on auction days through Treasurydirect.gov. Investors who want to buy at other times must go through brokers. Every six months, the government increases the face value of each TIPS in line with the consumer price index. Then it sends the interest payment on that new principal to the investor's account. Because the federal government taxes investors on the interest and principal gains of TIPS each year, many advisers recommend that they be held in IRAs or other protected accounts. At maturity, investors get their inflation-adjusted principal back. Investors are free to sell their TIPS on the secondary market. But the resale prices can be volatile.
Inflation-indexed mutual funds. The fund tracker Lipper lists more than 30 mutual funds that invest heavily in inflation-hedging instruments. While some are down for the year, top performers like FFTW's and Vanguard's have averaged more than 7 percent total annual returns since 2001.
Exchange-traded funds. The iShares Lehman TIPS Bond Exchange-Traded Fund is indexed to inflation-protected securities. While the share prices have dropped 3 percent in 2006, the ETF, launched in 2003, has so far notched a total annual return of 4.2 percent.
| INVESTMENT | CAN YOU LOSE MONEY? | PROS | CONS |
| I bond | No | Exempt from state and local taxes. Federal tax deferred until redemption. Can be totally tax exempt if used to pay for education. | Can't be redeemed in the first 12 months. Redemption in the first five years triggers a penalty of three months' interest. |
| TIPS | Not if held to maturity | Exempt from state and local taxes | Federal taxes due each year on interest and gains unless TIPS are held in a tax-protected account. |
| Mutual fund* | Yes | Dividends are reinvested. | Management fees and taxes can reduce profits. |
| Exchange-traded fund* | Yes | Dividends are reinvested. | Commissions, management fees, and taxes can reduce profits. |
This story appears in the October 23, 2006 print edition of U.S. News & World Report.
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