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TIPS on Hedging Inflation

By Margaret Schumacher

A common way to add some inflation protection into investment portfolios is starting to get more attention.

The U.S. government has signaled that it is going to greatly increase the amount of Treasury Inflation-Protected Securities, or TIPS bonds, that it will be issuing.

The way TIPS work is if inflation increases, investors’ return increases. The return is tied to the Consumer Price Index. So if that indicator goes up, then the return on the TIPS goes up.

They are a hedge. They’re sort of an insurance policy within an investment portfolio for inflationary times. Even in the rare occurrence of deflation, TIPS return to investors no less than the principal value when the bonds mature.

Bond researchers have forecast that the U.S. Treasury will issue between $80 billion and $85 billion in TIPS. That would be a record, potentially expanding the market by more than 15%. Forecasters expect up to $125 billion in TIPS in 2011.

Recent offerings of TIPS have received unprecedented interest from investors, with bids exceeding the number of securities available by ratios of more than three to one. And in February, the government brought back a 30-year TIPS for the first time in nearly a decade.

By offering more TIPS, the government could be setting up a number of scenarios.

  • An expanded market in TIPS might make them more attractive to big investors, including foreign buyers, who already own about half of the outstanding U.S. Treasury securities.
  • A larger market might also help make a more efficient market. On the secondary market, as with stocks and other securities, the pricing of TIPS has a lot of expectation built into it. So if there is a lot of fear of inflation, TIPS can do well, even if the actual inflation numbers aren’t that bad.
  • The expansion of TIPS will give the U.S. government some credibility as an inflation fighter. By putting out these bonds, the Treasury is taking a gamble that if inflation goes up, it’s going to end up costing the government more. So by saying, “We’re going to issue more of these bonds. We’re not afraid of inflation,” the U.S. government is assuring the world and U.S. investors that it believes it is on top of inflation and will be able to keep it under control.

I think at this point there’s at least a 50-50 chance that the Treasury and Federal Reserve Chairman Ben Bernanke may not be able to pull off what they want to, which is sucking all of that excess capital out of the system at just the right time and keeping a lid on inflation.

I don’t see any immediate inflation risk, but I do think it is prudent for investors to introduce small percentages – say 5% or perhaps up to 10% – of inflation-adjusted bonds or commodities or some other assets that do well in an environment of rising inflation.

Get more information on TIPS from the U.S. Treasury: http://www.treasury.gov/resource-center/fin-mkts/Pages/tips.aspx

Learn more from Treasury Direct: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm

Margaret M. Schumacher is a vice president at Landaas & Company. She is a Certified Financial Planner, registered representative and general securities representative.

initially posted May 5, 2010

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