Treasury inflation-protected securities (TIPS) have always bored me. They're unexciting, they usually offer puny returns, and they take some time to understand.
But there's a time for every investment, and now is the time to add TIPS to your portfolio. They're outrageously cheap, and they protect you against inflation, which is virtually certain to pick up in the coming years.
Bill Gross, manager of Pimco Total Return (symbol PTTDX) and other similar funds, notes that although the market has punished TIPS lately, their prices could quickly reverse course once investors begin to anticipate an economic recovery. Gross says a sharp rally in TIPS prices is likely within the next six months.
Here's how TIPS protect you against inflation. Every six months, the government resets the value of your TIPS based on the rise in the Consumer Price Index. TIPS immediately start paying interest on that higher amount of principal.
With the government running the printing presses 24 hours a day in an effort to ward off deflation, it's hard to believe the U.S. won't see a pickup in inflation once the financial crisis abates. "We like TIPS as an insurance policy on inflation," says Mark Kiesel, head of investment-grade bonds at Pimco.
But today's TIPS prices seem to suggest that future inflation will be practically nonexistent. A 10-year TIPS note currently yields about 2 percent, while a regular 10-year Treasury note yields only one-half percentage point more. That means that over the next 10 years, TIPS will do better than regular Treasuries if inflation is more than a mere 0.5 percent a year. A five-year TIPS note yields 2.25 percent -- slightly more than regular Treasuries. In other words, even if there is no inflation over the next five years, TIPS will earn more than standard Treasury IOUs.
What accounts for this unusual state of affairs? First, the bond market is expecting deflation -- that is, falling prices. Then there are the hedge funds, which are responsible for so many dislocations in all sorts of markets. When the economy was stronger, many hedge funds loaded up on TIPS -- often using borrowed money -- hoping to cash in on inflation. When investors started cashing out of hedge funds last year, their managers dumped TIPS -- not because they wanted to, but because they could sell them easily.
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