An expanding economy generally is a good thing, but the inflation it sometimes causes can be bad news for bond investors. That's because inflation erodes future purchasing power. In other words, today's dollar won't buy as much down the road. But luckily for investors, unique bond investments called inflation-protected securities are designed to benefit from rising inflation.

Understanding Inflation-Protected Securities

Treasury Inflation Protected Securities (TIPS), issued by the United States Treasury Department, are the most common U.S. inflation-indexed security.

Unlike conventional bonds, the principal of a TIPS adjusts for changes in inflation. The adjustment is based on the Consumer Price Index (CPI) published by the Department of Labor. The CPI measures average changes in prices of goods and services.

If inflation rises (as measured by the CPI), the principal of TIPS increases. If prices decline, the principal decreases. When a TIPS matures, the investor receives the original value of the bond plus an additional amount to account for inflation. If no inflation is reported in the CPI, the investor is assured of getting back the original principal.

TIPS pay a fixed rate of interest twice per year. The interest rate is applied to the adjusted principal, so interest payments rise with inflation and fall with deflation. The amount of each semiannual interest payment is determined by multiplying the adjusted principal by one-half the fixed annual interest rate.

Here's how it works. Let's assume an inflation-protected bond that costs $10,000 today promises a real return of 1.94%. That means the bond guarantees that, after one year, you'll be able to obtain 1.94% more goods and services. If inflation turns out to be 3%, the face value of the bond will rise to $10,300, and the bond will pay interest equal to 1.94% of the $10,300 ($200). But if inflation turns out to be 5%, the face value of the bond will rise to $10,500, and the interest payment will be $204.

Some government agencies and large corporations also issue securities that are designed to produce a return that attempts to beat inflation. These work a little differently than the TIPS, but the effect is the same - you get an inflation hedge. The most significant difference is that corporate securities are not backed by the U.S. government, as TIPS are, and may carry additional risks.

Investing in Inflation-Protected Funds

Inflation-protected mutual funds typically invest in inflation-protected securities. Some funds invest in TIPS exclusively, while others include inflation-protected bonds issued by corporations and government agencies.

Because inflation-protected bond funds invest in multiple bonds, they don't "mature" in the same way that individual bonds do. As a result, there's no guarantee that your investment will not lose value. However, a mutual fund of inflation-protected bonds can be an easy way for you to own them with a relatively low minimum investment and receive the benefit of professional management.

With many inflation-protected bond funds, principal adjustments are distributed as monthly dividends, and you will be taxed on these dividends. Because the dividends compensate for inflation, it's critical that you reinvest them in the fund. If you don't, you lose your investment's ability to beat inflation.

The interest payments from inflation-protected securities are taxed for federal income tax purposes in the year payments are received. The inflation adjustment credited to the bonds also is taxable each year. That means during a period of no inflation, the cash flows will be exactly the same as for a normal bond and the holder will receive the coupon payment minus the taxes on the payment. During a period of high inflation, the holder will receive regular cash flow, but will also have to pay additional taxes (sometimes called "phantom taxes") on the increase in the inflation-adjusted principal.

Analyzing Performance and Risk

Inflation-protected bond funds generally provide moderate price fluctuation and little investment risk, although longer-term issues can be more volatile. With both inflation-protected bonds and funds, default risk generally is of little concern due to the stability of their issuers.

It's important to remember that inflation-protected securities' principal value will fluctuate with inflation. That means these securities and funds that invest in them may not produce a steady income stream, particularly during deflationary periods. It's also important to remember that rising rates will have a negative impact on inflation-protected bonds and funds, just as they do on conventional fixed-income securities.

Assigning Portfolio Allocation

Inflation-protected securities target a rate of return above inflation and therefore enjoy a distinct risk/return profile. Because these securities tend to perform differently than stocks or stock funds in a given market environment, including them in a portfolio heavily weighted in stocks can potentially pave the way for smoother long-term performance. Many experts believe that for most investors, only 5-10% of an individual portfolio should be invested in inflation-protected securities.

This information is for educational purposes only and is not intended to serve as investment advice.