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|Includes: iShares TIPS Bond ETF (TIP)

In the most recent US Government auction of 5-year Treasury Inflation Protected Securities (OTC:TIPS), the yields actually dropped below zero for the first time ever - to minus 0.55%.  In other words investors are paying 55 basis points to the Treasury to borrow our money. Portfolio Research's eleven asset classes include TIPS.  For example right now our Risk Target 10 Strategy recommends a 10.4% allocation to TIPS. You may be wondering whether we are crazy, and whether it is necessary to include TIPS to build a properly diversified portfolio. Or perhaps you are wondering -- what on earth are TIPS?

TIPS are inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 30-year maturities.

We view TIPS as a valuable component of our effort to diversify and reduce risk - especially now with current correlations for equities, REITs and commodities high relative to long-term values.  TIPS are designed so that they have the potential to outperform many different asset classes during periods of inflation.  The best environment for TIPS is one where economic growth is low or falling and inflation is high or rising.  Under these conditions, TIPS may outperform other asset classes, particularly equities and nominal Treasury bonds.  On the other hand, the worst environment for TIPS is likely to be a period of moderate-to-high economic growth coupled with low or falling inflation.

To understand the return on TIPS prices you need to understand TIPS' "breakeven rate" relative to Treasury bonds of similar maturity. The breakeven rate, which you find by subtracting the yield of a TIPS issue from the yield of a regular Treasury bond of similar maturity, refers to the hypothetical future inflation rate that would cause TIPS and Treasury notes to break even with one another. When the break-even rate seems unrealistically low, TIPS are cheap relative to Treasuries and visa versa.

For example, as we note above, TIPS maturing in 5 years currently yield -0.55%.  Treasury notes due in 5 years yield approximately 1.33%.  This implies that if inflation averages 1.9% annually over the next five years, your return from holding the five-year TIPS and five year Treasury note until maturity will be roughly the same.

So if consumer prices rise at their long-term historical rate of 3.23% or more over the next five years TIPS will be a very strong investment.  On the other hand if inflation turns out to be lower than 1.9%, TIPS will not be as good of investment as Treasury bonds.  If real interest rates rise (nominal interest rates rise, but inflation holds steady) TIPS would suffer along with other bonds.

But even if we experience severe deflation, causing most asset classes to suffer, investors in TIPS will still get their original principal back at maturity.  So if we experience the Japan-style deflation that many fear, and CPI declines by 2% per year on average, investors buying TIPS last week will make a real return of 1.45% annually.

This is another reason we like TIPS - they act as an insurance policy that mitigates the dangers of both hyper-inflation and the severe dangers of deflation. There are arguments to be made suggesting the US dollar is facing inflation, as well as arguments that we face a period of deflation.   

ETFs such iShares Barclays TIPS Bond Fund (NYSEARCA:TIP) or Vanguard Inflation Protected Securities (MUTF:VIPSX) are among the cost effective ways we suggest to invest in TIPS.