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Weekend Edition: QE2 Sets Sail

How to Protect Yourself from Central Bankers

Written by Brian Hicks
Posted October 16, 2010

Welcome to the Wealth Daily Weekend Edition — our insights from the week in investing and links to our most-read Wealth Daily and sister publication articles.


Free of the dock, QE2 is about to leave the harbor.

Never mind the fact that these are completely uncharted waters; Chairman Ben sleeps tight tonight believing that his theories will eventually fill the sails.

However, there is at least one aspect of this voyage that everyone can agree on...

At some point in the future, this mountain of cash will be inflationary on a pretty large scale.

After all, inflation is the destination. Just ask Captain Ben.

In case you missed it, he’s been shouting it from a bullhorn for the past 6 weeks now.

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That's why the price of gold and other commodities is edging higher, as smart investors work to hedge themselves against these characters, their grand plans, and their printing presses.

But let's face it: Gold isn't necessarily for everyone. As a commodity, it can be highly volatile.

That's why more conservative investors are now moving a portion of their portfolios into Treasury Inflation Protected Securities as a way to combat future higher prices. You may know them as TIPS.

TIPS protect against inflation

Like all Treasuries, TIPS are debt instruments issued by your own Uncle Sam.

Essentially, he sells them to spend money he does not have. As with other Treasuries, they pay interest every six months and return the principal when the security matures.

However, the difference with TIPS is the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the consumer price index (CPI). So when inflation returns and the CPI rises, the coupon payments of TIPS and the underlying principal automatically increase.

That makes the win here twofold, since not only are TIPS based on one of the safest investments — U.S. Treasuries — but they are also hedged against inflation. So the real rate of return is guaranteed.

For example, let's assume that inflation goes through the roof next year and hits 10%...

If that were the case, an investor who purchased $1,000 in U.S. TIPS carrying a 3% coupon would see his principal automatically grow by 10% to $1,100. Moreover, because the coupon payment is based on the principal amount, the interest payment would also edge higher.

Nominal U.S. Treasuries, meanwhile, offer no such protection. That's why any whiff of inflation is a Treasury investor's worst nightmare.

Deflation is more their style.

As a result, TIPS share an inverse relationship with "regular" U.S. Treasuries. So as the bond bubble begins to burst, TIPS will naturally rally.

The downside to treasury inflation protected securities, though, is pretty simple: The CPI needs to go up, which it hasn't done much of over the last two years.

However, it's important to note that your principal with TIPS is 100% protected — that's why they offer a safer alternative to the wild price swings of gold.

How to  invest in treasury inflation protected securities

These securities can be purchased either directly from the U.S. Treasury or through a bank, broker, or dealer through the auction process based on their yield.

As an alternative to the direct purchase route, there are also bond funds available to investors that match the performance of the TIPS themselves. Typically these high-quality funds and ETFs will invest at least 80% of their funds in inflation-protected bonds.

The upside with these funds is that their investors get the added benefit of professional management. Moreover, these funds offer the liquidity that most investors need.

Here are two inflation-protected bond funds that closely match the performance of TIPS themselves:

  •  Vanguard Inflation-Protected Secs (MUTF: VIPSX): The fund invests at least 80% of assets in inflation-indexed bonds issued by the U.S. government. It may invest in bonds of any maturity, though the fund typically maintains a dollar-weighted average maturity of 7-20 years.
  •  iShares Lehman TIPS Bond (ETF) (NYSE: TIP): The fund invests at least 90% of its assets in the inflation-protected bonds and at least 95% of its assets in U.S. government bonds. It may also invest up to 10% of its assets in U.S. government bonds not included in the underlying index. Additionally, the fund invests up to 5% of its assets in repurchase agreements collateralized by U.S. government obligations and in cash and cash equivalents.

So while we all sit and wonder if the Fed's latest scheme will do the trick, the consequences of it all can be found just over the horizon.

Unfortunately, they include much higher prices...

After all, Captain Ben’s trip to Atlantis is just warming up. You can count on that.

As for some other places to invest your hard-earned labor, here are a few of the best investment ideas from the pages of this week's top-read Wealth Daily and Energy & Capital articles.

Have a great weekend.

Your bargain-hunting analyst,

steve sig

Steve Christ
Editor, Wealth Daily

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