Strong returns may not last on popular TIPS bonds

NEW YORK -- With the outlook for stocks still uncertain and many bonds overvalued, investors have been lured by double-digit returns on TIPS, the U.S. government securities that protect against inflation. But analysts are advising caution for anyone considering TIPS -- the good times might be coming to an end.

TIPS, short for Treasury inflation-protected securities, are bonds that eliminate the effects of inflation by adjusting the face value of the note and paying a flat return above the inflation rate.

It seems like a good option as stock prices bobble and money market yields dip to their lowest ever. Indeed, TIPS funds have returned 12.8 percent this year, and have averaged about 7.8 percent over the previous three years, beating out many stocks and bonds in a bear market.

"There are a lot of investors who have been scared out of the stock market and are ... suffering from low interest rate shock," said Michael W. Boone, a certified financial planner in Bellevue, Wash. "They're looking for a safe alternative. TIPS fit that bill rather nicely."

Investors have responded. Assets of mutual funds that invest in inflation-indexed securities in the United States and abroad have jumped to $9.9 billion this year from $3.9 billion in 2001, prompting firms such as Fidelity Investments and T. Rowe Price in recent months to begin offering TIPS funds.

A tough call

But analysts caution that the investments aren't without hazards. Like other bonds, TIPS are vulnerable to price declines if the Federal Reserve raises interest rates above their 41-year lows as recessionary fears lessen. There are also tax consequences, since interest on Treasury bonds counts as income on your tax return.

"It's tough to say" whether TIPS are still good investments, said Bradley Sweeney, a fixed income funds analyst at Morningstar Inc. "Right now, the bond market has gotten skittish with the positive economic numbers that have come out."

Here's how they work:

Like other Treasury securities, TIPS are issued by the U.S. government, offering protection from defaults. But while a regular 5 percent note, for example, would leave investors only with a 3 percent return if inflation is 2 percent, a 2.5 percent TIPS would pay 4.5 percent to account for inflation.

"By tagging this to inflation, it protects purchasing power," Boone said.

Still, investors can be hurt since funds that invest in TIPS are buying and selling securities all the time at various prices, creating short-term volatility and portfolio losses depending on when investors choose to get out.

Driven by Fed cuts

TIPS' recent value also has been driven by the Fed's unprecedented 12 rate cuts the past two years as well as high demand, which have pushed prices above their par, or face value. That could quickly reverse if the Fed boosts rates, spurring investors to flee TIPS.

And TIPS are best reserved for tax-deferred accounts since investors must pay federal taxes on the semiannual inflation adjustment each year, even if they don't sell the bond. That typically means an IRA since few, if any, employee-sponsored 401(k) plans offer TIPS options.

Still, financial planners say investors should consider TIPS as part of a diversified portfolio, particularly if they're seeking greater safety from price volatility than stocks or conventional bonds.

"The target audience for this sort of investment is more than likely an investor in a retirement phase who wants to preserve the purchasing power of their capital," Sweeney said.

But don't expect to get rich from them, especially as stocks seek to crawl out of their three-year bear market, analysts say.