But if inflation starts to creep up to a 3% annual pace or more, then even the interest you’re getting on your bond investments won’t be enough to keep your nest egg intact. The balance of your account might remain stable or modestly growing, but inflation will actually erode your purchasing power.
An alternative, then, is to invest in bonds that are benchmarked to inflation — Treasury Inflation Protected Securities, or TIPS.
TIPS payments are directly linked to the Consumer Price Index, so if this measure of inflation rises, you will get a bigger payout from your investments.
Interested investors can buy individual TIPS bonds from the government via Treasury Direct, or you can invest in a more diversified fund of these securities, such as the Vanguard Inflation-Protected Securities Fund (VIPSX) or the SPDR Barclays TIPS ETF (IPE).
But be warned that TIPS are not risk-free — particularly if consumer prices remain stable like they have been. If inflation doesn’t rise, you could be locked into a rather pathetic rate of return in these bonds that lags other low-risk alternatives like investment-grade government and corporate bonds.
Consider that in 2012, expectations for inflation were so high that the Treasury sold $15 billion of TIPS at a negative rate of -0.637%! Investors expected inflation to soar, and that this negative yield would be quickly moved much higher … but given the meager pace of inflation, these investors haven’t seen anything to show for their investment.