TIPS will earn interest, keep lid on inflation

Money Talk

Your Money

February 22, 2004|By MATT LUBANKO

WHAT are TIPS? Where can I buy them? And what are some of the risks and rewards of buying TIPS?

- C.D., Chicago

TIPS is an acronym for Treasury inflation-protected securities.

Also known as Treasury inflation-indexed securities, TIPS are issued by the U.S. government in 10-year terms. They can be purchased through brokers, directly from the government or within a mutual fund.

In recent years, it has been hard to find anyone to say a bad thing about TIPS. Institutional investors have grown to like them, after initially shying away from TIPS when Uncle Sam first sold them in 1997.

But before you buy TIPS, or invest in a mutual fund that trades TIPS, you should understand what they are, how they work and why they might not always represent a sound bet.

The first working part of TIPS can be found in the fixed rate of interest, also known as "the coupon." Ten-year TIPS issued in mid-January bore a 2 percent annual coupon, which means you'd receive $200 a year (in biannual installments of $100) for TIPS with an initial face value of $10,000.

Before you conclude a 2 percent coupon with TIPS adds up to a raw deal (shorter-term 5-year bank CDs currently yield an annual average of 3.56 percent, according to Bankrate.com), take note of the second working part: the inflation protection feature. This feature ensures that your TIPS will keep pace with the rate of inflation as measured by the Consumer Price Index, or CPI. The CPI is factored in twice a year.

To see how this works, let's assume the index rises by 2 percent during the first six months you own your 10-year TIPS. This semiannual rate of inflation would boost the principal of your note to $10,200 from $10,000. And this rise in that note's principal would boost the yearly cash income you'd receive from $200 to $202.

If the CPI were to rise at an even faster pace, your TIPS would rise at a pace equal to that widely reported rate of inflation. If, on the other hand, year-to-year prices were to fall, as last happened in 1954, then the principal of your TIPS could fall as well. Example: A 2 percent drop in inflation would clip your $10,000 in TIPS principal to $9,800.

There are other points to consider.

Although you do not receive cash on any appreciation when the principal of your TIPS rises from, say, $10,000 to $10,400, you are taxed as if you have received a yearly cash payment of $400. This means TIPS, in periods of especially high inflation (say 8 percent a year) could put you in a bind you've rarely, if ever, faced before.

"The taxes you pay on the phantom inflation-protection income could exceed the cash income you receive from the coupon," explained David M. Darst, a chief investment strategist at Morgan Stanley in New York. For this possible outcome alone, many financial planners say TIPS are best held inside tax-deferred savings vehicles such as IRAs, although TIPS are not taxed at the state and local level.

TIPS also could suffer if interest rates were to rise while inflation remained tame. While coupons and yields on other bonds would rise during a rising-rate scenario, low-coupon TIPS purchased today could amount to low-yield paper in a rising yield market, Darst said.

Despite these drawbacks, TIPS have become popular for several reasons. Compared with other U.S. government bonds, their prices have held up relatively well after interest rates rose from low points reached in mid-June 2003. And 10-year TIPS, with a coupon of 2 percent in January auctions, measure up well to 10-year Treasury notes. To beat 10-year Treasuries with a current yield of about 4.1 percent, TIPS only need the annual Consumer Price Index to exceed 2.1 percent over the next 10 years, which many believe is a safe bet.

To learn more, visit the www.publicdebt.treas.gov/sec/sectrdir.htm link at the Treasury Web site. To buy TIPS without going through a broker, you may also call 800-722-2678.

What precisely is beta? I see this term used in Morningstar reports on mutual funds.

- D.R., Allentown, Pa.

Beta measures a stock or mutual fund's movement vis-a-vis a broad market index. Beta numbers above 1 are said to represent stocks or funds that are more volatile than the Standard & Poor's 500 index.

Example: A fund with a beta of 1.5, based on its past behavior, would rise 15 percent during periods the S&P 500 would rise 10 percent.

Stocks or funds with a beta number below 1 tend to move less violently than the S&P 500. This includes downward as well as upward motion.

Matthew Lubanko is a financial columnist for The Hartford Courant, a Tribune Publishing newspaper. E-mail him at yourmoney@tribune.com.

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