Bond funds are popular with mutual fund investors because they provide stability, income and tax advantages in some cases. But one of the chief shortcomings of bonds is they are typically vulnerable to inflation, which erodes the purchasing power of their income over time. However, there is a type of fixed-income instrument that does offer protection in this area.

Inflation protected bonds are designed to pay rates of interest that grow with inflation over time and protect the investor’s purchasing power.

See also our Beginner’s Guide to Bond Mutual Funds.

The idea of issuing securities that provided protection from inflation is not a new one. Massachusetts Bay Colony offered money market securities that were indexed to the price of silver in London. Israel offered inflation-protected instruments in 1955 and the U.S. Treasury introduced Treasury Inflation-Protected Securities in 1997.

Be sure to also read A Brief History of Mutual Funds.

Treasury-Inflation Protected Securities (TIPS) provide a stream of interest that is guaranteed by the U.S. government. The rate of interest is comprised of a fixed coupon rate plus an increase in the face value of the bonds that is linked to the Consumer Price Index. For example, a $1,000 TIP that pays a 4% coupon rate would pay $40 of interest during the year. Then, if the rate of inflation was 5% for that year, the face value of the TIP would increase to $1,050. The coupon rate of the bond would then be $42 ($1,050 X 4%) which is paid on a semiannual basis. Of course, in return for their inflationary protection, TIPS pay much lower coupon rates than nominal bonds.

The interest that is paid on TIPS resembles that of nominal Treasury securities in that it is taxable only at the federal level. This interest is reported on Form 1099-INT, while any increase in the face value of the bonds will be reported on Form 1099-OID in the year that it was paid, regardless of whether the TIPS matured that year. Investors who hold their tips through TreasuryDirect.gov can elect to have up to half of the interest they receive withheld for taxes.

See also 10 Ways to Beat Inflation with Mutual Funds.

Because of their inflation protection, the values of TIPS in the secondary market will increase when inflation concerns rise and fall during periods of low inflationary forecast. Because the value of nominal bonds will rise and fall inversely to TIPS, the use of both types of instruments in a portfolio can lower its overall volatility. They can also be purchased tactically according to inflationary expectations in the same manner as nominal bonds are for changes in interest rates. Investors who want to profit from TIPS can do so by comparing them to like-kind nominal Treasury securities with identical maturities. The difference between the coupon rates of the two will represent the expected rate of inflation from their issuance to maturity.

Be sure to also see our Beginner’s Guide to Asset Allocation.

Investors who believe that the actual rate of inflation during this time will exceed the forecast would therefore choose to buy TIPS because the inflationary adjustment would get them a higher return than a nominal interest rate. Those who believe that the actual inflation rate will lag the projection will obviously choose nominal securities instead. Current holders of TIPS are also wise to wait until inflation forecast rise before selling and fall before buying. Of course, this form of market timing is every bit as difficult and risky as any other, and is especially risky in the short term because the Fed can only make predictions for long-term rates. It should be noted that TIPS have historically posted a relatively low correlation to the stock market over time.

As with nominal securities, individual TIPS are probably only appropriate in most cases for investors who need to structure specific cash flows. Other investors will usually be better off buying mutual funds or ETFs that invest in TIPS. As with other types of mutual funds, TIPS funds offer liquidity, diversification and professional portfolio selection and management.

One example includes:

• Alliance Bernstein Bond Inflation Strategy Fund (Class A ABNAX) – This fund has a two-star rating by Morningstar and $10,000 in this fund would have grown to $11,500 by October of 2014. The A shares have a maximum 4.25% sales charge and annual expenses of 0.8%.

If these returns don’t sound too appealing, remember that TIPS are usually more effective over the long-term and interest rates have hovered at historic lows over the past two years. And the values of TIPS can actually become negative if the inflation forecast drops low enough, as is shown in some of the above returns. Note that the positive return posted by the Alliance Bernstein fund covers a longer time period.

Inflation-protected bond funds provide investors with an opportunity to earn interest that keeps pace with inflation over time. They may even outpace inflation over time in some cases by using certain techniques. But they should typically be used as long-term instruments by most investors, and the annual tax bills that they post will reduce their returns accordingly. Nevertheless, these bonds can be used to reduce portfolio volatility and improve returns if they are used properly. For more information on TIPS and inflation-protected bond funds, visit the U.S. Treasury website at www.treasurydirect.gov or consult your financial advisor.

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