This Inflation-Fighter Is Too Expensive

There's nothing that sounds more ludicrous than accepting a negative interest rate on your money. At least in the case of a certain type of Treasury bonds, though, negative rates suggest that investors are willing to pay up for protection against a potentially huge threat looming on the horizon: inflation.

But what's particularly frustrating for income-seeking investors is that despite Treasury inflation-protected securities, or TIPS for short, seeming to be poised for a big ramp-up in consumer prices, those price increases haven't for the most part shown up yet. The net result may be that although long-term investors have seen some big gains from TIPS they bought years ago, current investors are likely dooming themselves to poor returns going forward.

Understanding TIPS
The way that TIPS work is a bit more complicated than a regular bond. Typically with bonds, you invest a certain amount, collect interest payments along the way, and then get your money back at maturity. With inflation, you expect that the money you get back years down the road will have less purchasing power than the money you initially invested had, but the interest payments you receive are meant to compensate you somewhat for that loss of purchasing power.

By contrast, TIPS do things somewhat differently. With TIPS, you don't just get your initial investment back at maturity; you get whatever the purchasing power of that money is, as measured by the Consumer Price Index. So if the CPI rises 50% between when you buy TIPS at auction from the government and when they mature, then you'll get $1.50 back for every $1 you initially invested -- and that $1.50 should theoretically buy the same amount of stuff that your $1 could when you invested it.

Why TIPS are winning
In a lost decade for stocks, bonds have performed exceedingly well. But looking back at the data, TIPS have outperformed even traditional Treasury bonds, with a total return of 111% over the past 10 years compared to a 73% total return for traditional Treasuries. Yet even with both five-year and 10-year TIPS at negative yields, some analysts expect further declines in rates. One pegged the 10-year TIPS to hit negative 0.4% by mid-year.

With traditional 10-year Treasuries around 1.8%, current TIPS yields imply a breakeven inflation rate of 2%. So if actual inflation accelerates to come in faster than that, TIPS will benefit. Yet if the Fed raises rates to fight inflation, TIPS prices could still suffer.

Two ways to fight inflation
If you really think negative real yields are worth it to get CPI protection, then you can buy individual TIPS at auction from the U.S. Treasury. Alternatively, you can turn to the iShares Barclays TIPS Bond ETF (NYS: TIP) and similar ETFs that own TIPS.

But personally, I think at today's yields you're better off going with inflation-fighting stocks. The reason: Strong companies can raise prices to combat inflation, maintaining their margins when competitors fail. Consider these four companies:

  • Starbucks (NAS: SBUX) has modestly raised prices on its beverages recently to cover increases in coffee and milk costs. Few expect much outrage from hikes that average out to about 1%.

  • Johnson Controls (NYS: JCI) raised prices of its well-known DieHard car battery line early last year. The move, which amounted to a 5% to 9% increase, helped cover increased regulatory and commodity costs.

  • Procter & Gamble (NYS: PG) has had to deal with rising costs of wood pulp and raw materials for toilet paper, diapers, and other paper products. The company passed on some of those costs last year in an overall price hike.

  • At McDonald's (NYS: MCD) , higher food costs led the company to increase its prices early last year. The company tries to make small incremental increases but isn't afraid to do so frequently to keep up with rising expenses.

These companies all have what many others lack: a dedicated customer base that's unlikely to defect at the first sign of a price hike, especially if it's understandable given what's going on in the overall economy. That should help you fight inflation better than accepting defeat from the start with negative real rates.

Keep your money
Inflation is a real long-term threat, even if it isn't imminent in the short run. Locking in negative yields on TIPS for 10 years or more is simply asking for trouble. You'll be better off fighting inflation the traditional way: with stocks that can keep up and beat inflation.

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At the time thisarticle was published Fool contributor Dan Caplinger stopped listening to TIPS a long while ago. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Starbucks. Motley Fool newsletter services have recommended buying shares of Starbucks, Procter & Gamble, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy keeps up with everything.

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