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Treasury Inflation-Protected Securities [TIPS} do exactly what their name suggests. They are U.S. Treasury bonds designed specifically to protect investors against inflation. To do that, both the interest and the principal payments are indexed against the Consumer Price Index. So the yield quoted on a TIPS security is a "real" return; that is, an incremental return that's added to the rate of inflation. Like other Treasuries, TIPS pay interest every six months and pay the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation.

TIPS are not an insignificant part of the fixed-income market. According to the New York Federal Reserve, as of July 31, 2008, TIPS outstanding totaled over $515 billion; or about 11% of marketable Treasuries outstanding. Average daily trading volume of TIPS by primary dealers in 2008 is close to $9 billion. That number is going to grow – just this week, $8 billion worth of 20-year TIPS went up for sale, which could potentially drive down yields in the short term.

TIPS can be used to market-time your expectations regarding inflation. To accomplish this, one must understand how to determine the embedded inflation expectation in TIPS. This can easily be done by comparing a TIPS' yield to that of a nominal U.S. Treasury bond. For example, if a nominal 10-year Treasury bond is priced with a yield to maturity (YTM) of 5%, and a similar TIPS is priced with a YTM of 2.5%, the implied inflation expectation would be 2.5%.

Using the example, if an investor believes inflation will actually move upward to 3.5%, that investor would buy a TIPS because it will become more valuable if actual inflation is greater than what the market expected. Conversely, if an investor believes inflation will be lower than 2.5%, or that deflation will occur, the investor will sell his or her existing TIPS.

Until very recently, TIPS prices seemed to suggest that future inflation would be practically nonexistent. A 10-year TIPS note was yielding between 2-2.5%, while a regular 10-year Treasury note yielded only one-half percentage point more. That means that over the next 10 years, TIPS will do better than regular Treasuries if inflation is more than a mere 0.5% a year. A five-year TIPS note that yielded 2.25% was only slightly more than regular Treasuries. In other words, even if there is no inflation over the next five years, TIPS will earn about the same as standard Treasuries.

What accounted for this unusual state of affairs? First, the bond market was expecting deflation, i.e., falling prices. Gasoline prices are down close to 60% from last July, and consumers are still cutting spending. That drives prices down sharply.

Then there are the hedge funds. When the economy was stronger, many hedge funds loaded up on TIPS, often using borrowed money hoping to cash in on inflation. When investors started cashing out of hedge funds last year, their managers dumped TIPS – not because they wanted to, but because they could sell them easily to raise cash and pay the investors.

There is some recent evidence that the appeal of TIPS is returning. On January 23, 10-year TIPS were priced for the Consumer Price Index to rise 0.72% over the next decade. That's a small increase, but it's the highest since November 17, and 15 times the almost-negligible inflation expectations of three months ago. The difference between 10-year TIPS and nominal Treasuries rose to 1 percent for the first time in more than three months.

The main reason for TIPS' recent popularity is that fixed-income traders are bracing themselves for government-sponsored inflation. Governments worldwide are starting to print a lot of money. Not only are politicians boosting government spending, but the Federal Reserve is expanding its lending to counter the worst economic slowdown in 25 years. President Obama's $819 billion stimulus package, which does not include an estimated $1 trillion bank rescue plan, is soon to be passed by Congress.

Bill Gross, manager of the Pimco Total Return Bond Fund [PTTDX], has become a big buyer of TIPS as an insurance policy on inflation. In a recent Barron's article, he forecast a sharp rally in TIPS prices within the next six months. Gross said the big TIPS payoff comes in the next six months if the de-leveraging cycle is halted and asset managers increase their liquidity. According to Gross, TIPS bottomed in November, and they can go up 10% or 20% in price simply on the basis of optimism that deflation has been averted.

Another inflation hedge traditionally favored by investors has been commodities, such as oil, gold or other precious metals. But in the past year, these assets have had very high volatility. Those wild swings make them less reliable for conservative investors. TIPS, because they are issued by the government, are more reassuring to investors trying to flee market volatility. You can buy TIPS directly from the federal government in increments as low as $100 at TreasuryDirect.gov. The other way to buy TIPS is through a mutual fund or an exchange-traded fund, such as the iShares Barclays TIPS ETF (NYSEARCA:TIP), an ETF with annual expenses of just 0.2%.

TIPS interact with the commodity markets in other ways, however. For instance, because so many investors buy commodities as a way to gain protection from inflation, many will use TIPS as their collateral when purchasing futures contracts. Typically, when investors buy commodity futures, they only have to put up a small fraction of the money for the contract: maybe 5-10%. The remaining money can be invested in ultrasafe Treasuries, or in TIPS. Using TIPS adds a second layer of "real returns" to the commodities position. Pimco, for instance, uses TIPS as collateral in its popular Commodity Real Return mutual fund.

The caveat with TIPS, other than their traditionally low returns, is that they represent a bet on moderate-to-high inflation, which may not occur. While aggressive government spending and rate cuts are likely to prevent full-blown deflation, negative government price data, if it occurs, would be bad news for TIPS holders, who would see their bond yields shrink in response. So here's one final "tip": Investors should buy TIPS as a worthwhile insurance policy on inflation, but shouldn't load up the truck unless they're completely confident prices are heading considerably higher in the coming months.

Source: Tips on TIPS: Treasury Inflation-Protected Securities