A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

Hot TIPS: Inflation-Indexed Bonds
We know that unanticipated inflation is devastating to
bondholders. Inflation tends to increase interest rates, and as
they go up, bond prices fall. And there’s more bad news:
Inflation also reduces the real value of a bond’s interest and
principal payments. Now a lead shield is available to
investors in the form of Treasury inflation-protection

---

securities (TIPS). These securities are immune to the erosion
of inflation if held to maturity and guarantee investors that
their portfolios will retain their purchasing power. Long-term
TIPS pay a basic interest rate of about 2 percent. But in
contrast to old-fashioned Treasuries, the interest payment is
based on a principal amount that rises with the consumer
price index (CPI). If the price level were to rise 3 percent next
year, the $1,000 face value of the bond would increase to
$1,030 and the semiannual interest payment would increase
as well. When the TIPS mature, the investor gets a principal
payment equal to the inflation-adjusted face value at that
time. Thus, TIPS provide a guaranteed real rate of return and
a repayment of principal in an amount that preserves its real
purchasing power.
No other financial instrument available today offers
investors as reliable an inflation hedge. TIPS also are great
portfolio diversifiers. When inflation accelerates, TIPS will
offer higher nominal returns, whereas stock and bond prices
are likely to fall. Thus, TIPS have low correlations with other
assets and are uniquely effective diversifiers. They provide an
effective insurance policy for the white-knuckle crowd.
TIPS do have a nasty tax feature, however, that limits their

---

usefulness. Taxes on TIPS returns are due on both the
coupon payment and the increase in principal amount
reflecting inflation. The problem is that the Treasury does not
pay out the increase in principal until maturity. If inflation
were high enough, the small coupon payments might be
insufficient to pay the taxes and the imbalance would worsen
at higher rates of inflation. Thus, TIPS are far from ideal for
taxable investors and are best used only in tax-advantaged
retirement plans.