Investors Turn To TIPS As Warren Buffett Warns On Inflation (TIP, STPZ, LTPZ, KO, IBM)

Don Miller: Warren Buffett last week did more than warn investors on the dangers of low interest rates and inflation. The Oracle of Omaha also had harsh words for traditional bonds.  In a Fortune article Buffett went so far as to say, “Right now bonds should come with a warning label.”

“They are among the most dangerous of assets,” Buffett  wrote, “Over the past century these instruments have destroyed the purchasing  power of investors in many countries.”

To prove his point Buffett labeled inflation as the primary threat to bond  investors, noting it takes no less than $7 today to buy what $1 did in 1965.

Instead of bonds, Buffett recommends “productive assets,” including farmland and real estate.

But he saved his highest praise for stocks, especially the stocks of  companies like The Coca-Cola Co. (NYSE:KO)  and International Business Machines Corp. (NYSE:IBM),  that consistently deliver inflation-beating returns.

But what if you’re not comfortable betting most or all of your chips on  stocks? And if traditional bonds are out, where else can investors turn for  inflation beating returns?

TIPS Insure Wealth Against Inflation

Enter Treasury Inflation Protected Securities, or TIPS.

Unlike regular bonds, TIPS are designed to protect your principal against  the ravages of inflation.

In fact, TIPS zig when other securities zag, providing diversification and safety to your portfolio.

TIPS are considered to be an extremely low-risk investment since they are backed by the U.S. government, and their par value rises with inflation while their interest rate remains fixed.

Here’s how they work.

Like conventional bonds, TIPS pay interest twice a year at a fixed rate. But  the principal of a TIPS bond is periodically adjusted to offset any increase in  inflation as measured by the Consumer Price Index (CPI).

When a TIP matures, you are paid the adjusted principal or original  principal, whichever is greater.

Investors should note the principal will also adjust to fall with deflation and the interest is subject to federal income tax, but exempt from state and local  income taxes.

There are two main benefits of TIPS.

The first is that they’re essentially Treasury bonds indexed to inflation. That eliminates one of the key risks for bond investors – rising  interest rates. By buying TIPS you’re  essentially betting on higher interest rates and inflation.

And with governments around the world unleashing untold  amounts of fiscal stimulus, there are plenty of investors who are buying TIPS  to get insurance against an inflationary cycle.

Second, debt sold by the Treasury Department is guaranteed by the full faith  and credit of the federal government. It’s fairly inconceivable that the folks  who actually print the money will default on their debt.

And if you hold TIPS to maturity you know exactly what you  are going to get: all of your money back, with interest, and with both  principal and interest adjusted for inflation.

How to Invest in Treasury Inflation Protected Securities

TIPS are also easy to buy.

You can buy new-issue TIPS directly  from the TreasuryDirect system in 5-, 10-, and  20-year maturities. Or you can get them  from a broker, an exchange traded fund (ETF) or a mutual fund. More than 20 fund companies offer TIPS funds.

Most analysts say TIPS are appropriate for most investors.

“TIPS should be part of every fixed-income  portfolio,” Donald Ellenberger, a government bond manager at Federated  Investors Inc. told Business Week.

So how do you know what to buy?

If you’re extremely concerned about a near term spike in  inflation you might consider buying a  short term TIPS or the PIMCO 1-5 Year U.S. TIPS Index (NYSEArca:STPZ).

 The yield is extremely low but it is almost a pure play on  inflation. They are also less risky than longer term TIPS. The ETF returned 6% over the last 12  months.

The sweet spot in terms of risk and return on TIPS is  probably around five years. Buy-and-hold  investors should do well by purchasing TIPS in those maturities or the iShares Barclays TIPS Bond ETF (NYSEArca:TIP). The fund returned  13.38% in 2011.

A long-term  buy-and-hold investor could purchase 20-year TIPS or the PIMCO  15+ Year US TIPS Index ETF (NYSEArca:LTPZ). The ETF returned  25.32% in 2011, slightly below the return on long-term Treasuries.

You might want to  consider owning all three.

By laddering a mix of ETFs with variable maturities, an investor could both diversify and restock his portfolio with a reasonable alternative to bonds.

After all, Warren  Buffett is right about inflation. That  makes TIPS a great hedge against the power of the printing press.

Written By Don Miller From Money Morning

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