by Andy H on April 11, 2009 | Updated May 15, 2013 | ETFs Mentioned: TIP

When the economy tanks, Treasury bills become a very popular investment. The downside is, when you combine increased demand for government bonds with very low inflation, these same Treasury bills pay extremely low rates of return. So low, in fact, that their real returns would virtually wiped out (and possibly turned negative) should inflation return to its normal rate. Not a pretty picture.

Enter TIPS: Treasury Inflation-Protected Securities. TIPS are government bonds that are guaranteed to adjust along with the rate of inflation. These TIPS are, quite simply, great little guys. In return for accepting a slightly lower return than normal T-bills would give you, you gain the peace of mind that if inflation goes up to 15%, youll still get a positive real return (yes, inflation has been this high before before, even if Im too young to remember it, and no, Im not talking a hundred years ago ). The fact that the spread between TIPS and regularly T-bills is so small makes me laugh at other investors whose memories are so infallibly short.

Let me be clear: I have no idea whether inflation or deflation is the larger risk in the short term. I am however fairly sure that over a 20- or 40-year time horizon (the horizon most of us are dealing with in our IRAs and 401(k)s), inflation is the much higher risk. Inflation is the norm. If youre holding a bond that pays 3% per annum, youre basically accepting that if inflation returns to a more normal state, you will accept a 0% or lower real return. Id rather accept a slightly lower real return now, and take the chance that the economy will return to a more normal state in the next 20 years!

I searched around the Web to see what other experts were saying. As I suspected, the experts have very mixed opinions about the short term, with many saying deflation is a higher risk than inflation, and vice versa. Most experts however did acknowledge that in the long run, inflation is sure to come backand many of them specifically recommend buying TIPS as well as TIPS ETFs. such as TIP (say that six times in a row, fast!).

So what should you do to protect your capital? Gold is an obvious answer and so are supersafe tips, or Treasury Inflation-Protected Securities. tips currently pay 1.95% plus a quarterly value adjustment based on the change in the CPI.

To protect a portfolio, Matthew Tuttle, president of Tuttle Wealth Management LLC in Stamford, Conn. recommends Treasury inflation-protected securities, known as TIPS, along with oil-related investments and real estate.

The addition of significant (20%) exposure to inflation-hedging assets like gold and TIPS is very appealing in the current environment, where many of us (even Jim) expect a major uptick in inflation.

John Jagerson in Profiting from Inflation with BOND ETFs (LearningMarkets):

From a fundamental and technical perspective it seems that one of the few things we can count on in this environment is higher levels of inflation in the long term. That may make the TIP ETF an attractive mid-term value play after the correction of the past few months. From a portfolio management perspective this is a good way to add protection against inflation and to insert an element of fixed income to your diversification strategy.

The Federal Reserve last week said it would buy $300 billion in long-term government bonds and $750 billion in mortgage-backed securities to help resolve the financial crisis. These actions will expand the money supply, which may lead to faster inflation. A weak economy and higher prices is a bad combination. As we stare down the barrel of this threat, it makes sense to add inflation protection to a diversified portfolio with Treasury Inflation-Protected Securities, or TIPS.

And just for the sake of fairness, Ill include a quote from the contrarians :

The Forbes.com Investor Team feels concerns about inflation are premature, as we remain locked in one of the worst deflationary periods on record. While inflation is a threat of the future, that future could still be far away. Still, the group does have thoughts on how to deal with both inflation and deflation.

Contrarians aside, its a safe bet that inflation will return in the next 20 years. If youre daytrading and believe were in a deflationary period, stay away from TIPS. But if you have a portfolio with a long term horizon, now might be the time to explore them.

Disclosure: At the date of publishing, the author currently owns shares of an ETF mentioned in this article: TIP.

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