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I Have Some TIPS For You

Posted by Larry Doyle on April 6, 2009 1:00 PM |

In the midst of the massive government intervention in the economy and markets, the Federal Reserve is providing measures of liquidity that are truly “off the charts.”  This liquidity, in the form of U.S. dollars, is flooding the economy. If and when the economy gains a little traction and the money multiplier kicks in, the growth in our money supply will skyrocket. What happens in the face of any market with increasing supply? Prices decline. In this case, the price decline in the value of the U.S. dollar spells INFLATION.

Many investors are questioning how to best position themselves for a potential increase in inflation. Various analysts are recommending commodities, real estate, and precious metals. However, while each of those assets can be a great store of wealth in the face of rising inflation, an investor is faced with a mix of fundamental and technical variables in determining the value of the asset. As a result, the correlation between rate of inflation and the performance of assets within those classes is not perfect. Is there an asset perfectly correlated with inflation? Come closer, I will give you a tip as to the asset class correlated to inflation.

 Treasury Inflation Protected Securities, yes TIPS, are U.S. government securities indexed to the rate of inflation.  

Like any bond, TIPS will rise or fall in value as interest rates change (rates up, bond prices down and vice versa), but they are indexed to inflation so will protect against a rise in inflation. I personally believe that interest rates will rise causing bond prices to decline. In light of that assessment, if I were to buy TIPS, I would buy shorter maturity bonds which are less sensitive to a shift in rates. As rates move higher, you can then buy TIPS with longer maturities. 

Aside from investing in TIPS to protect a portfolio against rising inflation, it is wise to keep an eye on the TIPS market as a measure of how investors believe inflation will move. If inflation expectations are increasing, the TIPS market will do well. If inflation is expected to decline or remain muted, then TIPS will underperform or be stagnant.

How did TIPS perform in March? I am glad you asked. TIPS were up 6% in March!! Investors clearly believe inflation is a real risk.

How can one buy TIPS?  Utilizing our trusty Investing Primer, we learn:

 How to Buy In
TIPS can be purchased in the same way as any other fixed-income investment: either directly as individual bonds through the U.S. Treasury or a broker, or through a mutual fund. If an investor is seeking to match specific cash flow needs, purchasing individual bonds makes sense. Buying bonds directly from the U.S. Treasury is the cheapest option in this regard. However, if the goal is to receive a fully diversified fixed-income portfolio of TIPS, a mutual fund is the best option, preferably a low-cost index fund. (To learn more, check out Evaluating Bond Funds: Keeping It Simple and Basics Of Federal Bond Issues.) 

A full, comprehensive review of Treasury Inflation Protected Securities is provided by Investopedia. 

….but don’t tell anybody!!


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