SAFE HARBOR:

At Your Finger TIPS: Get a hold on high inflation rates with treasury inflation-protected securities. (Scott Bernard Nelson, October 2004, Entrepreneur)

With traditional Treasury bills, bonds and notes, the interest and principal are fixed once you make the investment. Not so with TIPS. In the case of inflation-protected Treasuries, the interest rate is fixed from the time of purchase, but the principal changes in line with the Consumer Price Index (CPI).

Say, for example, you earned 2 percent on $10,000 worth of TIPS in year one of an investment. If the CPI increased 4 percent in that time, then the next year, you'd still earn 2 percent on your investment—but the interest would be calculated from a base of $10,400. If we entered into a period of high inflation, the principal amount would move rapidly higher and protect your purchasing power.

There's just one big problem with TIPS. The interest rate you have to accept to get inflation protection is substantially smaller than you'd find with traditional Treasuries. If the going rate on 10-year TIPS is 2.25 percent, and the rate on traditional Treasuries is 5 percent, inflation would have to average 2.75 percent over the next decade for you to come out ahead with inflation indexing.

Even so, it's worth considering TIPS for at least a portion of your fixed-income portfolio. Consider it a hedge against higher inflation, if nothing else.

They'll be an especially attractive option in a privatized social security system for for people who have retired.

Posted by Orrin Judd at September 3, 2004 10:17 AM