Financial Planning Blog

As discussed in Part 1 and Part 2, Treasury Inflation Protected Securities (TIPS) are an excellent hedge against unexpected inflation and one of the safer investments available. Although these bonds are not without risk (e.g. if real interest rates rise) and you should not expect high real (after adjustment for inflation) rates of return, they have a potential supporting role in many portfolios. Besides the obvious inflation protection, TIPS provide desired diversification--over time they are expected to be negatively correlated with equity returns, and relatively uncorrelated with the returns on conventional bonds.

If you decide to include TIPS in your investment portfolio, what is the best way to do it? You have two major routes to invest--each with alternatives to consider.

Direct investment in TIPS--individual bonds

Although not the simplest method, buying individual TIPS has some advantages. Like other U.S. government bonds, you can buy them directly through with no fee through TreasuryDirect.gov in increments of $100. This is a pretty easy process once you have an account set up, and over time you can create a very nice bond ladder. There are a couple of key drawbacks to this approach, however. First, you cannot set up an IRA in at TreasuryDirect, so you have to deal with the inefficiencies of TIPS in a taxable account as mentioned in Part 2. And, if you don't hold the note to maturity, selling through TreasuryDirect is not as simple, and is not free.

An alternative to using TreasuryDirect is to use your broker, bank or dealer to purchase the individual bonds. This will allow you to buy and sell them within an IRA, but there will likely be transaction fees that eat into your returns somewhat.

TIPS funds--actively and passively managed mutual funds and ETFs

If you like the simplicity and convenience of using mutual funds and ETFs for investing, here are some choices for investing in TIPS. Since expense ratios will cut into your return, you need be especially careful you to pay attention to cost. After all, TIPS are not expected to have high returns in the long run-and even the least expensive funds eat up a good share of the expected returns in this low interest rate environment.

The largest TIPS mutual fund is Vanguard's Inflation Protected Securities Fund (VIPSX, 0.25% expense ratio), which surprisingly is not an index fund. Vanguard's fixed income team believes the TIPS market is one where they can add value through some active management, while still keeping costs low. (Lower cost Admiral shares (over $100K) and institutional shares are also available.) Although Vanguard has some investment flexibility in the fund, they generally stay focused on TIPS and seek to take advantage of opportunities in that market.

Two other actively managed mutual funds that are well respected are PIMCO Real Return Institutional Fund (PRRIX, 0.45% expense ratio) and Harbor Real Return Fund (HARRX, 0.60% expense ratio)--both managed by the PIMCO team. PRRIX is available in many 401K plans, but requires a $100K minimum for individual investors. Both PRRIX and HARRX take a more active management approach, often holding up to 20% of the fund outside of TIPS, and may be considered more volatile than the Vanguard fund.

If you are looking to invest in TIPS via index-following ETFs, look to iShares Barclays TIPS Fund (TIP, 0.20% expense ratio) or State Street's SPDR Barclays TIPS ETF (IPE, 0.18% expense ratio). TIP is by far the larger of the two, but both of these funds seek to track the Barclays Capital U.S. TIPS Index in a cost efficient manner. PIMCO has also recently introduced a series of three new TIPS ETFs which track Merrill Lynch indexes. Most interesting is the PIMCO 1-5 Year U.S. TIPS Index Fund (STPZ, 0.20% expense ratio) which is designed to be more of a "pure-play inflation-protection investment". By concentrating on TIPS with shorter maturities this fund should expose investors to less risk of rising real interest rates. There is also the PIMCO 15+ Year U.S. TIPS Index Fund (LTPZ, 0.27% expense ratio) and the PIMCO Broad U.S. TIPS Index Fund (TIPZ, 0.30% expense ratio), which should be somewhat comparable to the iShares TIP and State Street IPE funds.

Conclusion

A recent Wall Street Journal article discussed how fear of inflation fueled by high government spending has sparked a significant increase of investor funds going into TIPS funds during 2009. Indeed, TIPS have posted healthy total returns so far in 2009, after losses in 2008. The fact that TIPS are hot right now is not a good reason to invest. Invest in TIPS if you think it makes sense as part of a long term asset allocation strategy. If you don't have such a strategy, consider consulting with Table Rock Financial Planning, or another fee-only planner from the Garrett Planning Network.