A few weeks ago, I had the pleasure of reading a White Paper by Cutwater Asset Management. The paper is titled, “Inflation Protected Bonds – How TIPS Can Drive You Tipsy” and discusses the lack of correlation between the returns on Treasury Inflation Protected Securities (TIPS) and gusts of inflation.

TIPS were created to give investors protection against the devastating effects that inflation can have on the loss of purchasing power. Inflation is the biggest enemy to bond prices and interest rates. In actuality the returns on these bonds have little to do with inflation. I consider it a very good idea that was executed in a very poor fashion. TIPS are a bond where the coupon is set for the life of the security and the principal due at maturity is adjusted annually to reflect the change in the U.S. Consumer Price Index (CPI).

In our opinion, the problem here is two-fold:

1) You don’t get the additional principal until maturity.

2) There is tax due on the phantom income if held in a taxable account.

We would much rather seek the protection of the TIPS brethren in the corporate bond markets called Corporate Inflation Protected Securities (CIPS). These bonds have a coupon that adjusts for the gross changes in the CPI. Thus, the investor gets immediate cash flow for changes in inflation and has the funds to pay any taxes generated. Granted, there is a credit difference between the credit of theUnited Statesand that of a corporation that must be considered.

Treasury Inflation-Protected Securities (TIPS) are bonds issued by the U.S. Treasury with a fixed interest rate whose principal changes monthly by the rate of CPI. Securities may lose value. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make an informed investment decision. AAM and its representatives do not provide tax advice.

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