Right now might be a great time to buy TIPS, especially in a tax advantaged accounts such as Roth IRA or 401k.   For those who aren’t familiar with TIPS.  TIPS are Treasury Inflation Protected Securities.  So what are they?  They are U.S. government bonds similar to the 2 Year Note or 10 Year Bond offered in 5,10, and 20 year maturities.  The difference is unlike regular government bonds which have a fixed interest payment, the “interest” payment on TIPS has two parts, the “regular” interest and an inflation portion.

The regular interest portion behaves mostly like interest on any other U.S. Bond.  The payments are made semi-annually.  The tricky part is that the underlying “face” value of the bond varies.  Typically a bond with a face value of 1000 will have it’s interest payments, say 5%, based on that face value.  Hence annually the interest payment would be $50 on a $1000 bond.  With TIPS that face value is adjusted for inflation.  So if inflation rate 5% in one year, the interest payment instead of being 5% of 1000, would be 5% of $1050 or $52.50. $1050 is the principal amount adjusted up to reflect the 5% inflation that has occurred.

The problem with bonds, and especially TIPS is a problem of taxes.  Even though U.S. Government issued securities are exempt from state and local taxes, you still have to pay federal taxes on them.  This is a problem with all bonds, but especially a problem with both TIPS and Zero Coupon Bonds, bonds that do no make annual (semi-annual) interest payments.  In the case of the Zero Coupon Bond, all implied annual interest is effectively paid out when the entire bond matures.  However taxes on that implied interest must still be paid even though the Bond itself makes no annual interest payments.  In the case of TIPS, taxes need to be paid on both the interest payment, and the principal adjustment.  Like the interest on the zero coupon bond the principal adjustment does not actually become realized until the bond matures.  As a result, taxes need to be paid on income that never actually gets distributed in that year.

So why am tipping towards TIPS?  As I’ve indicated before I’m concerned with the health of the U.S. Economy even with the half point cut the Fed made earlier this September. I’m about as invested (in the stock market) as I want to be given the prevailing economic conditions.  I even took some steps to hedge my exposure to the stock market in August.  Those hedges haven’t worked out so well, but that’s what hedges are suppose to do (or at least that’s what I tell myself).  As a result I have some cash in my IRA account sitting in a money market fund.  Inflation despite relative benign numbers as of late, remains a substantial risk especially if the Fed continues to cut rates.  By putting my money into TIPS, I can protect myself a bit from both inflation risks, and interest rate cuts.  TIPS like regular bonds appreciate when interest rates go down.  Given that there’s a decent probability that rates which might lead to higher inflation, TIPS are an excellent way to take advantage ever so slightly both of those risks.

Investing in TIPS is not a no brainer though.  There are many people including myself who are skeptical of the use of the CPI (consumer price index) as the best gauge of inflation which happens to be the index that TIPS use.   I would also be very hesitant to invest in TIPS in any kind of taxable account or as a primary investment strategy.  In taxable account, taxes eat away at the inflation protection.  The CPI could be 10% and the TIPS adjusts by 10% just to keep up, yet after taxes of 30%, the investor is down after adjusting for inflation.  Also for most individual investors the best way to invest in TIPS are through bond funds such as VIPSX (Vanguard), FINPX (Fidelity), and PRRIX (Pimco).  I actually haven’t done much research into the different funds as I make my inflation protected investments through my 401k which only offers one option, a flavor of the Vanguard fund.