One steady bit of good economic news: Inflation remains near zero. So who would want to pay extra these days to add a dose of inflation protection in their portfolio?
Plenty of people. It turns out sales are hot for Treasury Inflation-Protected Securities, a common hedge against rising prices best known by their acronym TIPS.
New money from investors and market gains have boosted total assets in mutual funds investing in TIPS nearly 36 percent so far this year, to $57 billion at the end of August, according to Morningstar Inc.
The value of the underlying investment in TIPS rises with inflation, providing an additional layer of protection beyond what Treasury bonds offer.
Hardly anyone expects inflation to re-emerge as a big threat anytime soon, so TIPS aren't necessarily the best short-term investment. But historically low interest rates and the federal government's growing deficit are expected to drive prices higher, especially once the economy truly gets back on its feet and spending rebounds.
Here are some common questions and answers about TIPS:
How do TIPS work?
TIPS are a type of Treasury bond that adjust their yield based on changes in the Consumer Price Index, an inflation yardstick tied to prices for goods and services. The principal in TIPS adjusts every six months. The so-called "coupon" rises when inflation grows, and decreases in the less-likely instance of deflation.
When the bond matures, you're paid the adjusted principal, or the original principal, whichever is greater. TIPS are sold in maturities of five, 10 and 20 years. Inflation had historically averaged 2 percent to 3 percent until falling to near zero when the market tanked last fall and deflation fears set in.
How have TIPS' market values held up lately?
Inflation and interest rate expectations are constantly changing, which is reflected in the prices traders are willing to pay for TIPS. Lately, TIPS have generally been seen as a good deal. Mutual funds investing in TIPS have returned an average of 8.63 percent so far this year, according to Morningstar. That puts TIPS funds in the middle of the performance pack among fixed-income fund categories.
What are my options for buying TIPS?
You can buy TIPS directly from the U.S. Treasury at treasurydirect.gov and avoid brokerage fees.
If you're not sure you can keep the bond until maturity and are nervous about managing your investment over time, you can buy into a mutual fund that focuses on TIPS, or an exchange-traded fund. Like TIPS mutual funds, TIPS ETFs hold baskets of TIPS with varying maturities, but can be traded like a stock.
Morningstar's current two favorite TIPS funds: Harbor Real Return (HARRX) and Vanguard Inflation-Protected Securities (VIPSX).
If you buy TIPS directly from the government, consider a "ladder" approach - owning bonds of varying durations that mature at staggered intervals to help manage risk and ensure steady cash flow. When one TIPS reaches maturity, it's replaced by another one as you approach retirement.
TIPS appear to carry little risk. Is that the case?
Any bond is subject to risk from rising interest rates, and TIPS are no exception. If the Federal Reserve boosts interest rates faster than inflation grows, or before inflation sets in, TIPS' values will erode. They can also be hit in a falling market, as happened last fall.