Inflation remains weak, but for how long? If you’re worried about the impact of rising prices, now may be a good time to buy a mutual fund that invests in Treasury Inflation Protected Securities (TIPS).
Many financial pundits have been forecasting higher inflation for years. 
But dangerous levels of inflation have yet to materialize. Just a few days ago, the Labor Department said the Consumer Price Index (CPI) edged up just 0.1 percent last month as a rise in food and shelter costs offset a decline in energy prices.
With inflation that low, it may seem counter-intuitive to buy TIPS funds now. But there are some compelling reasons to take a closer look.
TIPS and TIPS funds have two primary purposes in an investment portfolio. First, they act as an insurance policy against inflation, which clearly is hard to predict. Second, they can generate decent returns.
As an insurance policy, TIPS funds can be used as a hedge against rising prices because the underlying TIPS holdings are guaranteed to pay a return above the rate of inflation. As a return generator, TIPS are best when inflation is heating up.
Therefore, the best time to buy TIPS funds may be now. Here’s why:
When inflation is low-to-modest but expected to rise significantly in the near future, an investor can take advantage of a low price environment by buying shares ahead of the herd. In other words, you want to buy when higher inflation is not already priced into the net asset value of the TIPS mutual fund.
With the help of hindsight, let’s go back to 2011. Then, inflation fears were beginning to climb as the United States and world economies were looking like they had seen the worst of the credit crisis and were ready for faster growth.
Using a high-quality, low-cost TIPS index fund, Vanguard Inflation-Protected Securities (VIPSX), as a performance benchmark, one can see the price movement of TIPS funds in comparison to a broader bond market index, the Barclays Capital Aggregate Bond Index:
- In 2011, when inflation was above 3%, VIPSX jumped 13.2%, whereas the BarCap Aggregate rose 7.8%.
- By 2013, inflation had fallen back down to the 1.5% to 2.0% range. VIPSX fell 8.9% and the BarCap dropped just 2.0%.
- Year-to-date in 2014, VIPSX and BarCap returns are a lot closer with 3.7% and 4.1% gains respectively.
Of course, the decision to buy TIPS funds in the current environment is very much one of risk management. TIPS are a good tool for protection against an unanticipated jump in the rate of inflation. But talk of deflation is becoming louder and a deflationary environment can be devastating for returns on TIPS funds.
Recent volatility in stock prices also underscores investor nervousness over near-term market and economic strength. If you think stock prices are in a short-term correction mode and that prices for consumer goods and services will begin rising faster, then a bet on TIPS funds makes sense.
For a long-term investor, TIPS funds can always play a prudent role in a well-diversified portfolio. For this purpose, consider a broad index fund, like Vanguard Inflation-Protected Securities or an ETF like iShares TIPS Bond (TIP), which has a diverse selection of TIPS holdings with an average effective duration of 7-to-10 years.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
