Treasury Inflation-Protected Securities, or TIPS, are starting to gain some traction with senoirs and fixed
income investors looking for a bond like return while still being adjusted for inflation.  With TIPS, your capital is adjusted each year to reflect the current changes in the CPI.  TIPS come with a fixed return or coupon that is generally less than Treasuries but have an important benefit in high inflation.  Traditional treasury investments are not protected by rising inflation while TIPS are, thus they have a lower yield.

Currently TIPS return a less than stunning 1% per year.  Thanks to the credit crunch and general market worries, investors have poured capital into TIPS seeking income with protection from the high inflation that we are currently seeing.  The downside is that the yields on TIPS are terrible even after being adjusted for inflation.

This is how TIPS work, say you invest $25000 in TIPS at the 1% rate.  This will produce an annual income of $250 in interest payments.  If inflation were to rise by 4%, your principal will be adjusted by 4%.  Your $25000 bonds quickly become $26000 bonds because of the 4% adjustment.  The next years payment will be on $26000 rather than $25000 and you’ll receive a payment of $260 the next year.  In theory, TIPS make a great investment because you’re always beating inflation, even if only by 1%.  The problem comes in the way government calculates inflation which is centered around certain products and services and doesn’t represent a true growth in money supply or truly higher prices.

Right now the government would have to report inflation higher than 2.2% to make TIPS better than standard Treasury bonds.  The possibility for 2.2% inflation is great, but the possibility for government recognized inflation of 2.2% isn’t as great.  Much calculation is done in the inflation statistics which ultimately hides the true inflation amount.

The better bet for protecting yourself and your capital from inflation is in commodities like gold and silver where the supply remains relatively constant and prices rise and fall due to rising inflation or deflation.  To mimic the returns of TIPS, an investor should seek investments in gold and silver mining companies that pay a dividend.  Chances are that you’ll be able to find plenty of stocks with a 1%+ dividend and the rising cost of gold will cancel out inflation.   Add capital gains on top and you’re already doing better than a government adjusted security.  TIPS just aren’t the right way to go.