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.
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.
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