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TIPS Seem Safe, But They Can Destroy Your Nest Egg

TIPS, or Treasury Inflation-Protected Securities, have come into fashion during the past few years — especially as the hyperinflation hawks complain about easy central bank policies and sovereign debt woes around the globe.

These instruments are tied to the Consumer Price Index, a common measure of inflation, and the principal adjusts upward as the CPI moves higher over time.

Sounds great, doesn’t it? TIPS are the ultimate hedge against inflation and a bulletproof place to hide out if the market continues to tank and central bank policies cause inflation to heat up.

Well, maybe not.

For starters, it’s a minority opinion that the markets will crash; most expect an up year in 2013 and clear signs of a recovery in 2014.

And even if the market is doomed for a big correction, there still are serious risks to investing in TIPS based on the boogeyman of hyperinflation.

The low-risk appeal is compelling if you are in capital preservation mode. But capital preservation is about all you’ll get from TIPS. Consider the Treasury Department recently sold $9 billion in 30-year TIPS at its highest yield in more than a year … and that yield was a meager 0.639%. That was actually up from the record-low 0.48% yield the Treasury commanded in October … but it’s hardly a way to grow your nest egg, even if it protects what you’ve got.

Furthermore, the spread between 30-year TIPS and conventional 30-year Treasury bonds is roughly 2.55%. This means investors need a 2.55% average rate of inflation just to match the returns they would get in regular 30-year bonds.

In 2012, inflation was just 2.1% for the full year, and January CPI ticked up a meager 0.3%! So why not just go with conventional bonds or bond funds — especially if the Fed is talking about tightening policy and raising rates in the next year or two?

Dan Wiener, editor of the Independent Adviser for Vanguard Investors, thinks TIPS are useful as a short-term cash alternative since you’ll get more than you would by sticking the money under your mattress … but beyond that, TIPS don’t have all that much to offer. Says Wiener:

“Short-term TIPS might make a good cash substitute but longer-term TIPS are, to my way of thinking, way over-priced and, when interest rates rise, will take a hit like any other Treasury bond. Look at what Vanguard’s doing in three of its Target funds — getting rid of its longer TIPS and going with shorter TIPS. They’re even getting out of cash in two of those funds and putting the money in short TIPS, just as I argued when they first introduced the short-TIP fund.”

The fact the widely held Target funds in the Vanguard family (those are the funds you might recognize from your 401k with specific “retirement dates” on them like 2035 or 2045) are moving from long-term TIPS to short-term TIPS is telling.

Or put more bluntly, “hiding in TIPS” for the long-term is “silly,” according to Wiener, who also says:

“First off, where’s the inflation? By any measure it’s running under 2%. That’s barely inflation. We have plenty of unused capacity, we still have high unemployment, there really isn’t any pressure point that is going to push inflation higher, quickly.”

If you do want to protect yourself in the short-term with TIPS, Wiener suggests the Vanguard Short-Term Inflation-Protected Securities Index Fund (MUTF:VTIPX) for “short-term money you didn’t want to spend tomorrow.”

But investors need to be wary about hiding out in TIPS — not just because they will fail to deliver returns if inflation remains modest, but because your portfolio will miss out on larger gains in other asset classes should the recovery continue in earnest across 2013 and into 2014.

Yes, TIPS are very low-risk and provide an inflation hedge. But they don’t offer much upside amid modest inflation and the threat of higher rates in the near future. Investors need to remember this before they plow too much into TIPS from Treasury Direct or by investing in TIPS via a fund like the iShares TIPS Bond ETF (NYSE:TIP) or the SPDR Barclays TIPS ETF (NYSE:IPE).

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP

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