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Treasury Inflation Protected Securities (TIPS)

Written By Brian Hicks

Posted February 12, 2009

Fear… anxiety… dread… and catastrophe.

Those are the top four themes of the new administration these days.

And needless to say, it’s not exactly the message of hope that swept them into the Oval Office. In fact, it’s just the opposite.

But that’s politicians for you. When they find themselves backed into corners like this one, fear becomes their new best friend as they work you over for more money to buy votes. "Spend it or suffer the consequences," they warn. All of them do it when it suits them.

That makes the latest crisis something of a porky political jackpot. The scary mention of the word depression practically sells itself.

But while the fine folks in Congress haggle over a few billion here and a few billion there, the true size of the actual black hole goes largely ignored.

Because the real number makes the latest political theater nothing more than a puny, little side show. In reality, the U.S. taxpayer is already on the hook for as much as $9.7 trillion. And that was before the tax-challenged Treasury Secretary, Tim Geithner got out a pencil of his own. Apparently, he is still adding it up.

That would be the current equivalent of 9,700,000  million-dollar bills if there were such a thing—a number entirely too big for anyone to begin to understand.

The funny thing is it’s almost enough to pay off every single mortgage in the entire country, and a full $8 trillion of it has never even been voted on by lawmakers!

Instead, it has been chained to the taxpayers by fiat alone, courtesy of the FDIC and the Federal Reserve. So much for a representative democracy.

But what makes it most appalling is this: No one knows for sure if it will work. 

In fact, on Tuesday, Tim Geithner practically admitted as much when he signaled to the markets that Congress is making it up as they go along. The markets have been down ever since.

However, there is at least one aspect of these "rescues" that everyone can agree on. At some point in the future, this mountain of cash will be inflationary on a pretty large scale. There is virtually no argument about that. After all, inflation is the goal. Just ask Helicopter Ben.

That’s why the price of gold 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’s 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 Insure Wealth Against Inflation

Like all Treasuries, TIPS are debt instruments issued by your own Uncle Sam. He sells them to essentially 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 in the world’s safest investment—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 in the last four months. 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.

After all, while it may be quite easy to purchase TIPS directly, selling them is another matter entirely. Bond ETFs, naturally, make that prospect a breeze.

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 seven to 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 latest rescue will do the trick, the consequences of it all can be found just over the horizon. Unfortunately, those consequences are much higher prices.

After all, Helicopter Ben and his political friends are likely just warming up. And besides fear, inflation is their real best friend.

You can count on it.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

PS. The enormous bubble in U.S. Treasuries means not one – but TWO – blockbuster profit opportunities for Ian Cooper and his readers. This explosion could produce two chances for returns even greater than the 927% Ian racked up in just 2 months as the financial and insurance companies began crumbling last fall.

Click here to learn how you can profit TWICE from this bubble.