Are you taking steps to protect your portfolio against inflation. Though we really havent seen it yet, many are afraid that the steps that have been taken over the past few years to stimulate the economy will inevitably result in elevated inflation.

Well, Vanguard just published an interesting article about the risks associated with Treasury Inflation-Protected Securities (TIPS). In it, they argued that investors that are looking to add TIPS to their portfolio in hopes of protecting themselves against inflation are taking on relatively high levels of interest rate risk.

Said another way, bonds rates are at all-time lows. If (when) rates eventually move up, existing bonds will be less attractive to investors and thus their values will fall. If youre holding actual bonds (as opposed to TIPS mutual fund) then this is just a paper loss unless you sell before maturity. But its a real risk, particularly if theres a chance that youll need the money prior to maturity.

In truth, interest rate risk isnt unique to TIPS. All marketable bonds are exposed to this sort of risk. But bonds that arent indexed to inflation are expected to pay whats referred to as an inflation premium i.e. their rate will be higher to compensate for the risks associated with owning a non-inflation-indexed bond in a potentially inflationary world.

As of now, TIPS have real (inflation adjusted) yields near 0%. Thus, while theyll help you protect the value of your current dollars, you shouldnt be looking for much in the way of real returns over the long run. If we hit a period of high inflation, youll do okay. But if we dont, you may not achieve desired returns.

Of course, TIPS arent the only way to hedge against inflation. You could, for example, buy Series I Savings Bonds or even resist the temptation to pay off your mortgage early (or even take out a bigger one).

As for us, though weve long since paid off our mortgage. we do have a healthy dose of TIPS and we also pick up our annual allotment of I bonds each year.

Ultimately, I have no idea what tomorrow holds and neither do you so I figure its better to diversify and ensure that, while our approach is unlikely to be 100% right, its unlikely to be 100% wrong.

Published on September 19th, 2012