Sunday, December 16, 2007

Inflation Protection For An Investment Portfolio

Last week economic inflation reports showed wholesale inflation rose at the highest rate in 34 years, while consumer prices rose the most in more than two years. One way an investor can protect an investment portfolio from the negative effects of inflation is by investing in Treasury Inflation Protected Securities, commonly referred to as TIPS.

The distinguishing characteristic of TIPS is the principal is adjusted periodically by the level of inflation. The face value of a TIPS is adjusted based on the consumer price index for all urban consumers (CPI-U). As detailed in an article by the Association of Individual Investors on TIPS:
"This inflation adjustment also applies to the coupon interest thrown off by TIPS. The interest rate of TIPS is set when the bonds are sold, at auction. That rate never changes. But because the face amount of the TIPS is adjusted at the rate of inflation, interest income rises as the value of the TIPS rises: The interest income computation is applied to a rising base. Note, however, that interest rates at auction vary as the general level of interest rates varies."
An investor needs to remember that one aspect of TIPS is the additional interest earned due to the inflation adjustment is added to the face value of the bond, but an investor is taxed on this additional earned interest.
"The main attraction of TIPS and TIPS funds is that they provide a hedge against future inflation and insure a modest, but real rate of return over long holding periods."

TIPS for Inflation-Proofing Your Portfolio: A Guide to Inflation-Indexed Securities
American Association of Individual Investors
By: Annette Thau

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