Treasury TIPS: A Looming Disaster for Small Investors

Treasury TIPS: A Looming Disaster for Small InvestorsDuring the last few years, many small investors hoping to add some insurance to their portfolios invested in Treasury inflation-protected securities, otherwise known as TIPS. As the Treasury Department wanted us to know, TIPS "provide protection against inflation."

So now that inflation is again on the horizon, those investors should be sitting pretty, right? Wrong. It turns out TIPS are a horrible investment when the economy is facing higher inflation.

TIPS, you see, protect investors against a rise in the core inflation rate as measured by the consumer price index. But another, more important, phenomenon occurs when inflation hits: Interest rates go up. And when rates rise, bond prices go down. So your TIPS are protected against a rise in the CPI -- which, by the way, seems bizarrely to be moving down even as gas and food prices soar -- but as the markets react to this problem, rates are going up.

This was brought home by an excellent article in the Financial Times by Jeremy Siegel, a professor at the University of Pennsylvania's Wharton School of Business. "As economic growth recovers and real rates rise, the price of TIPS will fall, leaving TIPS investors with large losses in the face of accelerating inflation," Siegel wrote.

So much for inflation protection.

Where to Move Your TIPS Money

"There's going to be a heap of pain out there for people who bought TIPS thinking, 'I have got to protect myself against inflation," says Marilyn Cohen, CEO of Envision Capital and the author of a forthcoming book called Surviving the Bond Bear Market: Bondland's Nuclear Winter. "They will get walloped by higher interest rates and lower bond prices."

As the title of her book suggests, Cohen believes a bond bear market started last October, just before the Federal Reserve announced it was going to buy $600 billion in Treasury bonds in an effort to get interest rates to go even lower. "Bond investors around the world said, 'Oh-oh, they're going to be printing more money, and this is not going to work,' " Cohen says.
So, what should an investor with a portfolio full of long-term TIPS do now?

Siegel obviously prefers investing in stocks, referring to the long-term return of equities, which he says historically have averaged 6% to 7%. That's true, as long as you don't count the last 10 years, when they've returned very little.

Cohen says she remains a bond fan but would switch to intermediate or short-term bonds -- not bond funds.

How do you replace your safe Treasurys with something equally secure? Stick with names you know, she says: bonds from established corporate entities like Johnson & Johnson (JNJ) or even high-yield debt from the likes of Wynn Resorts (WYNN) in Las Vegas.

"Stay in front of the yield curve, which means seven years or shorter," Cohen says. "Sacrifice a little bit of yield today for the flexibility of being able to buy lots of something at higher yields down the road."

But wherever you move your funds, it's vital to recognize this: Bonds, especially government bonds, are no longer the great safe investment they have been for the past 30 years.

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