Some tips for those feeling the inflation pinch

With inflation topping 4 percent, Treasury Inflation Protected Securities have added luster.

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Today's slowing economy has increased consumers' inflationary fears. Gasoline and food prices keep surging higher. Many investors, particularly those on fixed incomes, are rightfully concerned that their investment returns are not keeping pace with rising consumer prices. Inflation poses not only a risk to purchasing power, but also to investments, significantly lowering real returns.

Over the past decade, inflation has averaged 2.5 percent annually. But from December 2007 through May 2008 that average has jumped to 4.1 percent, according to inflationdata.com.

Some investors who wish to protect their assets from inflation are shifting to Treasury Inflation Protected Securities. Created in 1997 by the US Treasury, TIPS offer the highest correlation with inflation, a negative correlation with stocks (when stocks rise, TIPS lag, and vice versa), and lower correlations with ordinary bonds. So it's no surprise that investment managers strategically allocate portfolios to include TIPS as an inflation hedge.

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Unlike traditional government bonds, TIPS increase interest payments in an inflationary environment. The Treasury adjusts the principal value of the underlying bond every month, based on the Consumer Price Index (CPI). In times like these, the result is higher principal and interest payments. One caution: The adjustments lag by three months.

While TIPS are as volatile as any other bond with day-to-day price fluctuations, when held to maturity, TIPS pay out either the inflation-adjusted principal or the original value of the bond, whichever is greater. Hence, there is no principal risk. If the bonds are sold prior to maturity, however, the value is affected by the interest environment. Adding TIPS to your portfolios will enhance diversification and increase capital preservation.

How do TIPS stack up against other investments? Consider this comparison: Investing at the beginning of this year in the Vanguard Institutional Index Fund, which mimics the S&P 500 index, would have resulted in a capital loss of 11.91 percent (as of June 30). Putting that same amount in a six-month certificate of deposit maturing at the end of June would have resulted in a 4.58 percent annual percentage yield, or a 2.26 percent return over that six-month period.

For the same period, an investment in a TIPS mutual fund such as the Vanguard Inflation-Protected Securities Fund, would have gained 5.16 percent.

Joel Ticknor, a financial planner from Reston, Va., urges clients to include TIPS in their portfolios, though the allocation level varies depending on their risk profile.

Mr. Ticknor recently introduced his clients to a new TIPS Exchange Traded Fund (ETF) from State Street called WIP that allows investors to hedge against global inflation.

How do investors gauge if TIPS add value to their portfolio? In today's investment market, where inflation has already been factored into TIPS pricing, you will not find the same financial advantages that would have occurred if they had been purchased earlier during this inflationary period.

To see if purchasing TIPS is worthwhile, determine the average yield of a 10-year Treasury Note and subtract the value of 10-year TIPS to view the inflation expectation over that decade. For example, on July 1, 10-year Treasuries were trading at a yield of 3.98 percent while 10-year TIPS were trading at 1.43 percent. The expected annual inflation rate would be the difference, or 2.55 percent.

Some strategies to guide your TIPS investment:

•Consider allocating 10 to 15 percent of your overall portfolio to TIPS products, depending on timing in the market and your perspective on inflation.

•Place TIPS in a nontaxable account such as an IRA to avoid federal taxes on both interest income and principal gain. Be wary – you will eventually have to pay taxes, and after doing so may not have beaten inflation.

•Realize that TIPS are not easily traded and may result in a loss depending on the interest-rate environment if sold prior to maturity.

•Purchase TIPS through Treasury Direct (treasurydirect.gov), a broker, or a mutual fund company that offers a TIPS fund. If you do not reinvest interest payments, you will lose long-term interest return.

•Recognize that TIPS are simply a hedge against inflation. Protect against deflation by also purchasing either Treasuries or equities.

•Expenses matter on a TIPS account. Select a no-load, low expense (20 basis points or lower) product where possible.

Dr. Kathleen Connell is a professor at Haas Graduate Business School, University of California, Berkeley.

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