TIPS

(This is a follow-on to my post on worry free investing.)

TIPS is an acronym for Treasury Inflation Protected Securities. The objective of TIPS is very similar to I-Bonds which I described in an earlier post. The idea is to offer a safe investment whose objective is to track the rate of inflation. Basically it is designed to protect the purchasing power of money over time. Again, in my opinion TIPS are one for the best investments available for tax-deferred and tax-exempt accounts such as 401(k)s, IRAs, Roth IRAs, etc.

Unlike I-Bonds the interest rate is fixed, but the principal adjusts with inflation. Every 6 months a fixed rate of interest is paid on the inflation-adjusted principal. At the time of maturity, the holder of the bond either receives the face value of the bond or the inflation adjusted principal, whichever is higher. TIPS are sold in maturities of 5, 10, and 30 years.

The reason why I say that TIPS work best in tax-deferred and tax-exempt accounts is because any changes in the principal due to inflation in a given year are subject to tax in that year. I don't like the idea of paying taxes on changes in principal before the bond matures. Of course, if you need an investment that works similar to TIPS for a taxable account, the right vehicle would be I-Bonds.

There are several ways to own TIPS.

• Mutual funds such FINPX and VIPSX. There are 2 things to be cautious about. The first is expenses. As of this writing, the expense ratio for FINPX is 0.45% and that for VIPSX is 0.25%. Expenses eat into the total return, and given that these investments are just about keeping up with inflation, one should be very careful about fund expenses. The second thing is that funds constantly have to buy and sell bonds on the open market because of investors buying into or selling their position in the fund. As a result, they are subject to market ups and downs.
• Closely related to mutual funds are Exchange Traded Funds (ETFs) such as TIP. This has the same problem as mutual funds -- expenses and being subject to market ups and downs. In addition, one usually has to pay a brokerage fee to buy or sell them since they are traded like stocks. As of this writing the expense ratio of TIP is 0.20%. This is slightly less than for both the mutual funds mentioned above, but you do have to factor in the brokerage transaction fees.
• Holding the bonds directly in a brokerage account till maturity. I think this is best way to own these bonds. Many brokerages offer these for purchase at treasury auctions for no fee. This is how I have been buying them. If this is something of interest, you should check with your brokerage about how to participate in auctions. The bonds are offered only a few times a year. For bonds offerings during the current year, you can look at the schedule put out by the US Treasury. If you decide to go this route, also pay very close attention to those issues marked as "Reissue". Because they are reissues, they essentially command the market price for what the original issue is selling for. I didn't know about this when I first started buying these, but now that I know about it, I probably won't be buying securities from an auction when they are marked as a reissue.

You can get more information on TIPS at TreasuryDirect.

TIPSwatch is a nice blog dedicated to the subject of TIPS.