TIPS Funds Are In Market Sweet Spot

As inflation worries mount, so does the demand for inflation hedges. Treasury Inflation Protected Securities have been popular.

As their name suggests, TIPS rise with inflation. Increased demand has lifted TIPS prices this year. Ten-year TIPS issued July 16 were auctioned for $99.34 per $100 of value. When the Treasury issued more of the same debt three months later, investors bid the price up to $102.72.

As a result, funds holding these bonds have excelled. The group's total return this year going into Wednesday was 9.29%. That topped all fixed-income categories tracked by Morningstar. It also beat the 6.87% average gain for U.S. diversified stock funds.

TIPS funds jumped nearly 1% on Tuesday, as U.S. stock funds plunged. The funds rose on investor reaction to the Federal Reserve's quarter-point cut in the federal funds target rate to 4.25%.

Many investors had hoped for a bigger rate chop to thaw credit markets and juice the economy. But the Fed evidently felt a larger cutback risked fueling inflation too much. That inflationary danger cheered TIPS investors Wednesday.

But can the TIPS party last?

"Generally, rising inflation should be good for TIPS," said Ken Volpert, co-manager of the $12.1 billion Vanguard Inflation-Protected Securities Fund (NASDAQ:VIPSX - News). If prices rose sharply, TIPS funds could continue to outperform other types of bond funds.

Through Oct. 31, the consumer price index showed an inflation rate of 3.5% for the trailing 12 months. That was up from calendar 2006's 3.4% and 2005's 3.3%.

Many money managers on Tuesday said the Fed would have to trim rates more soon to encourage lending. But if that fuels inflation, it will help TIPS more.

The Fed has cut rates by a total of 1 percentage point 14 its last three meetings. TIPS investors see this economic glass as half full. In their eyes, rate cuts free up more money to chase too few goods. That's the very definition of inflation.

Too Little, Too Late?

TIPS investors aren't assured of a happy result. Tuesday's cut could lead investors to fear that the Fed is doing too little, too late to prevent a slowdown, Volpert says.

An economy slowing too fast would check inflation. And expectations of lower inflation can cut the appeal of TIPS and cause funds holding those bonds to underperform.

Just as Fed actions can affect TIPS funds, the same is true of the actual inflation numbers, which are released each month. TIPS funds probably will respond to those numbers.

If inflation rises, increasing demand for TIPS could boost the returns of those funds.

But big rate hikes and hawkish talk from the Fed could calm fears of inflation. Then TIPS might lag conventional Treasuries.

Falling inflation could sap demand for TIPS, sending them and TIPS funds lower.

What if inflation holds steady? TIPS are likely to move up with Fed rate cuts and down with rate hikes.

With TIPS, the yield is set when the bonds are issued. That fixed yield is a "real" yield, which means it is the amount by which yield tops the inflation rate.

TIPS yields are below 2% now.

In addition, TIPS investors get an inflation adjustment. Every six months, the value of the bond goes up, to match the inflation rate.

As the value of a TIPS bond increases, the real yield stays the same. But the interest paid goes up.

Say you buy $10,000 of TIPS with a real yield of 1.6%. At that rate, the annual interest payment is $160, or 1.6% of $10,000.

But suppose your TIPS gradually increase in value to $11,000 because of inflation adjustments. Then the annual interest payment would be $176, or 1.6% of $11,000.

So investors' returns come in two parts: real yield and the inflation adjustment. The tax treatment may be an unpleasant surprise.

Say you buy TIPS with a real yield of 1.6%. In the first year, inflation is 3.5%. Your return that year would be 5.1%. And you would owe federal income tax on a 5.1% return.

But you would receive only the 1.6% real yield. You won't get any inflation adjustment until the TIPS are sold or redeemed.

Having It All

This problem can be addressed by investing in TIPS through a fund.

TIPS funds generally make distributions to investors that cover real yield plus the inflation adjustment, says Eric Jacobson, a Morningstar director of fixed-income strategies.

So you can receive all the money on which you're being taxed.

But most investors in TIPS funds reinvest distributions, so they buy more TIPS. If you do that, you'll owe tax without getting any cash from your TIPS.

One solution: Hold TIPS funds in a tax-deferred account such as an IRA. You won't owe tax until the money is withdrawn.