See also our Beginner’s Guide to Bond Mutual Funds.
History of Inflation-Protected Bonds
Be sure to also read A Brief History of Mutual Funds.
How Inflation-Protected Bonds Work
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.
How They Can Be Used
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.
Individual TIPS vs. Mutual Funds
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.
The Bottom Line
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