By Janice Revell, contributor
FORTUNE -- Nothing stokes inflation fears like the prospect of the Federal Reserve pumping unlimited amounts of new money into the economy. And in September the Fed said it would do just that, announcing an open-ended program to buy billions of dollars in mortgage-backed securities each month until the employment picture improves. Investors responded by bidding up prices for stocks and commodities, both of which have historically served as good hedges against inflation but can also bring unpredictable volatility. For a more stable form of protection against rising prices, consider instead putting some money into Treasury Inflation-Protected Securities, or TIPS.
Fear of inflation has also boosted demand for TIPS lately, and prices have been on the rise -- so much so that investors have been willing to accept negative yields in recent months just to get their hands on them. The reason is the built-in cushion these government bonds offer against rising prices. Unlike normal Treasury bonds, the principal value of TIPS is adjusted twice a year to reflect changes in the consumer price index. Interest is based on the adjusted amount, so that when the CPI rises, so, too, does the interest payment.
To help determine whether TIPS are offering fair value, you need to calculate the "inflation breakeven" figure, which compares the 10-year Treasury bond yield with the 10-year TIPS yield. That difference represents the rate of inflation that needs to exist over the next decade for TIPS to be a better investment than ordinary Treasury bonds. As of mid-October, the TIPS breakeven stood at about 2.5%. That's higher than the actual inflation rate of 2.0% over the past 12 months, but well below the long-run average annual rate of 3.6% since 1980. Many pros, like Pimco founder Bill Gross, believe that even after the recent run-up in prices, TIPS still represent a good value. TIPS also offer good portfolio diversification. According to Neil Leeson of Ned Davis Research, TIPS have relatively low correlation to stocks.
Investors can purchase TIPS directly from the government, at TreasuryDirect.gov. Beware, though: You'll owe annual federal taxes not only on the interest income but also on the inflation adjustment to the principal -- the latter of which you won't actually receive until the bond matures. For that reason it's best to hold TIPS inside an IRA or other tax-deferred retirement account, where you won't owe any taxes until you withdraw the money.
Another good option is to buy TIPS through an exchange-traded fund, such as the Pimco 1-5 Year U.S. TIPS Index (STPZ) or iShares Barclays TIPS Bond (TIP). A major advantage of buying an ETF over an individual bond: If you're holding the ETF in a regular taxable brokerage account, any inflation adjustments will get distributed to you as income. That way you'll at least have the cash on hand to pay the bill when the IRS comes knocking each year.
--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.
This story is from the November 12, 2012 issue of Fortune.
Just about everyone believes inflation is coming. But when will it actually get here?
Soon, if you listen to the trading in Treasury Inflation Protected Securities. The yield on five-year TIPS -- government bonds that pay additional principal when consumer price inflation rises – closed at a record negative 0.44% Wednesday.
Buying a TIPS bond with a negative yield means locking in a certain loss if inflation fails to materialize. Inflation has MOREColin Barr - Oct 14, 2010 12:23 PM ET
|Tesla repays federal loan nearly 10 years early|
|How police can find your deleted text messages|
|HP soars as Meg Whitman turnaround continues|
|How much did Tumblr's VCs really make?|
|Stocks slip as Fed sends mixed message|