TIPS, otherwise known as Treasury Inflation Protected Securities, have taken some hard knocks this year. Many investors are surprised at the losses. They may have believed having inflation protection is the same as being invulnerable.

It isn't.

At mid-year, Morningstar data shows Vanguard Inflation Protected Securities Fund (ticker: VIPSX) as having lost 1.67 percent for the period. The iShares TIPS exchange traded fund (ticker: TIP) lost 1.87 percent over the same period. The Fidelity Inflation Protected fund did much the same, losing 1.80 percent. The American Century Inflation Protected fund didn't escape, either. It lost 1.85 percent.

Losses, of course, are relative. In a rising interest rate market, most fixed income funds will lose value. The funds with the longest maturities (or durations, if you want to get technical) will lose the most.

That's exactly what we've seen so far this year.

The iShares Lehman Long bond exchange traded fund, duration 13 years, lost 6.40 percent in the first six months of the year. At the other end of the scale, the iShares Lehman short term Treasury exchange traded fund, duration 1.7 years, gained 0.96 percent.

Query: Should we reconsider our enthusiasm for inflation protected securities? Answer: I don't think so. Here are three good reasons to favor them.

Reason No.1: Inflation is the primary enemy of fixed income investments. Investors who bought traditional fixed coupon bonds in the '60s and early '70s lived to see an inflation rate that was nearly double the coupon rate on their bonds. If they sold their bonds before maturity, they lost market value. If they held to maturity, they got their original investment back, but they lost a major portion of their purchasing power.

If the purchasing power of your original investment is inflation protected, you've eliminated the single largest worry in fixed income investing. That's what TIPS do: Buy one and you know that you will get your original investment back, adjusted for the CPI. Along the way, your interest payment will be increased to reflect interest on the increased principal value.

Adjusting the value of principal at redemption, however, isn't the same as market value before redemption. That will fluctuate. And it will tend to fall as interest rates rise.

Reason No.2: Investors tend to underestimate inflation. As a consequence, they often underestimate how much the CPI adjustment will add to their return. In the current market, for instance, you can get 5.03 percent nominal yield on a 5-year Treasury note. Or you can get a 2.45 percent yield on a 5-year inflation protected security. Unless inflation is at least 2.58 percent over the next 5 years, the traditional T-note will provide the better return.

In fact, the June CPI report carried these figures for trailing inflation rates:
  • Compound annual rate for 3 months ended June 30th: 5.1 percent;
  • All items less food and energy, 3 months ended June 30: 3.6 percent;
  • Unadjusted 12 month rate ended June 30: 4.3 percent.
While some, including Federal Reserve Chairman Ben Bernanke, expect inflation to slow later this year, the expectation is hardly unanimous. If inflation runs at 4 percent for the year, as it may, TIPS investors would only need a 1 percent real rate to get the same nominal return as a traditional note. But the market is pricing TIPS for a 2.45 percent premium.

This is not unusual. To check, I visited the Federal Reserve website and downloaded its data on both the traditional 5-year constant maturity index and the 5-year TIPS constant maturity index. When I added the trailing 12-month inflation rate to the TIPS yield, I found the TIPS yield, looking backward, was usually superior to the 5 year note rate.

In the 42 monthly periods from January 2003 through June 2006, the TIPS index plus inflation beat the nominal Treasury yield 36 times. The average advantage was 66 basis points. (The graph below shows the TIPS plus inflation yield and the advantage over 5 year notes in the same period.)

Is that conclusive evidence? No, it's just an indication.

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Reason No. 3: Investing is about purchasing power. We tend to forget this against the abstractions of "yield," "total return," and dollar figures with lots of zeros in them. In fact, the reason most human beings save and invest is to provide future purchasing power when we can no longer earn money by working. (Yes, some people save and invest as part of their plan to rule the world, but they are a tiny minority.)

This is where inflation protected securities, purchased as individual securities, have a unique role in our portfolios. While we may invest in inflation protected mutual funds while we are accumulating money, we are better served by individual securities when we are older and distributing money. A TIPS investment can provide assurance that $1,000 of purchasing power today will be $1,000 of purchasing power at maturity--- even if the security matures with a nominal value of $1,500.

Information resources on the web:

Current quotes on Treasury yields at Bloomberg

Economic Indicators for trailing inflation rates (see page 24 of monthly reports)

Bureau of Labor Statistics CPI report

Federal Reserve historical interest rate data