Inflation 'protection' to go without

TIPS are Treasurys that pay an even lower yield but protect your investment by adjusting their value upward to match the inflation rate. That's why Pimco calls them "real return" bonds; you get the nominal or "current" yield and an adjustment to your principal. For example: If you have a $100 real-return bond and inflation runs at 4% this year, its value will be ratcheted up to $104.

With inflation fears so high, the value of this principal protection goes up -- and so the yield goes down. On five-year bonds, the yield is now 0.3%, or 30 basis points; on two-year TIPS, it's minus-25 basis points.

So if inflation continues at 4% this year, you would actually lose money. In effect, you'd pay $104.25 for a bond that will be worth $104.

Recession, not inflation?

Inflation is now running at 4%, but until recently the average was only 2%. In a recession, that higher rate is likely to trend toward the lower one. That means TIPS prices would decline. By the end of this year, TIPS mutual funds could be in the red.

They aren't likely to stay there very long.

"If you ask me, the chances over the next 10 years are that we'll see inflation close to 3%," Worah says. "A, the Fed is cutting rates aggressively, and low interest rates encourage inflation. B, it's our view that the dollar will continue to decline against many of those countries we import goods from, and that will lead to inflation in the United States. C, rising commodity and food prices are causing wage costs and inflation to go up in emerging economies, and at some stage that has to pass through to the United States."

Indeed, one reason TIPS are so expensive is that many investors believe the United States will experience inflation despite recession -- stagflation. Pimco is not forecasting that, however.

So Worah is shifting assets in his fund toward very-long-term TIPS bonds. Current yields are as high as 1.79% for 30-year bonds. Combined with an assumed 3% inflation rate, that suggests a total future annual return of 4.79%. Conventional 30-year Treasurys are yielding 4.36%.

A trend you can time

Conventional wisdom preaches that you should always own inflation-protected bonds if you are worried about inflation, because you can't predict when it will wax and wane. And indeed, if you feel you can't, own them despite their risk.

But I think you can predict the trend of inflation and therefore decide when to own these bonds and when not to own them.

I'm not alone. In our Start Investing community, a longtime member identified as "FPP" responded in February to a thread asking, "Do you think a TIPS fund is a good idea at this time?" His answer was no. "TIPS are an excellent diversifier, but one can time them pretty easily, so don't buy them now." (Read the full post here.)

FPP is not a market timer, by the way. He notes that he owned a TIPS bond fund last year but sold it in November. I also owned TIPS last year and have also sold them.

So he and I have missed out on TIPS' recent gains. And we might miss more gains in the months immediately ahead. But eventually, recession is going to bite. As an attractive, timely investment, TIPS have left the building.

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At the time of publication, Tim Middleton didn't own any securities mentioned in this article.

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