Friday, June 26, 2009

Inflation Protection – Part 4 – TIPS

Lending money to issuers of fixed debt securities when inflation is high is a prescription for certain losses at the prevailing inflation rate. So why would I lend my money to the United States Treasury when I expect inflation to pop sometime in the next several years?

The answer is TIPS, Treasury Inflation-Protected Securities. TIPS are US Treasury Bonds with contracts that call for increases in the bond principle based on the movements on the Consumer Price Index (CPI). The interest rate is fixed but when the principle is adjusted the actual semiannual interest payout moves up and down with the principle.

The face value at the time the bond is issued is an absolute floor on the principle of the TIPS Bond. If inflation has increased the principle since the bond was issued the bond principle can fall if the CPI falls but it can fall no further than the original face value.

I have heard that the Treasury cooled on new issues of TIPS. If true, it is itself a signal that the United States Treasury expects higher inflation and wants to sell conventional bonds for as long as they can get away with it.

TIPS can be purchased directly from the Treasury or in the open market. In addition, they are packaged into specialty TIPS mutual funds and ETF’s.

I chose to buy TIPS through the Vanguard TIPS mutual fund for my traditional IRA account. If you buy TIPS in an IRA the principle appreciation is under the IRA account’s tax protection. However, if you buy TIPS in a taxable account the IRS requires payment of capital gains tax on the inflation induced increase in principle.

TIPS bonds offer low risk inflation protection for your principle and the interest income derived from it.

Links to the Inflation Protection Special Report
Part 1 - The Need
Part 2 - Gold
Part 3 - Oil
Part 4 -TIPS
Part 5 - Consumer Staples
Part 6 - Commodities
Part 7 - Summary


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