Before we do, let’s look at another way to address the issue of inflation: building a laddered portfolio. This involves buying a roughly equal amount of bonds that mature in each of the next 10 years, and then replacing the maturing bond with a new 10-year bond. You would have a portfolio with an average maturity of five years that would balance/diversify the risks of deflation (when reinvestment risk shows up) and inflation (when term risk rears its ugly head).
If rates have fallen when the first bond matures, the other nine bonds would still be earning above-market rates (though you would have to invest the proceeds at lower market rates). On the other hand, if rates rise, you’ll be able to invest the proceeds at the now higher rates when the first bond matures.
Another benefit of a ladder is that after the initial period your portfolio will have the risk of a five-year bond but will have earned the average of the yields on the 10-year bond.
With TIPS, you win either way. If inflation shows up, the return of your bonds keeps pace. With deflation, they do at least as well as in inflation because TIPS mature at par (though to be fair, nominal bonds would have performed better).
For example, a 10-year TIPS with a yield of 1 percent at par with inflation of 3 percent per year yields a nominal return of 4 percent a year and a real return of 1 percent. However, with deflation of 3 percent a year, the nominal return is still 1 percent a year, but the real return (the only return that matters) is 4 percent. You also have an added bonus in deflation, since for taxable accounts taxes on due on the nominal return
How to Hedge Both Inflation and Deflation (MoneyWatch Wise Investing) August 25, 2010