From Dustin Woodard,
Your Guide to Mutual Funds.
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If you like the idea of investing in fixed investments, like treasuries, but don't like the idea of inflation eating away at the principal you are lending the government, then you may be interested in a product called Treasury Inflation Protected Securities.

What are Treasury Inflation Protected Securities?

Other than a mouthful of words, Treasury Inflation Protected Securities, or TIPS, are simply a special type of treasury note or bond that was created in order to offer bond investors protection from inflation. Being the biggest risk for bond investors, curbing inflation made this security very attractive when it was first issued in early 1997.

How Do Treasury Inflation Protected Securities Work?

The value of the TIPS are automatically adjusted to the inflation rate as measured by the Consumer Price Index (CPI). If the CPI goes up by half a percent the value of the bond would go up by half a percent. If the CPI falls, the value of the bond does not fall because the government guarantees that your original investment will stay the same. You can buy TIPS through a bond fund if you would like to let a manager do the dirty work.

What's the Catch?

Sounds too good to be true? Purchasing Treasury Inflation Index Securities comes at a cost. The interest rate paid by these securities is lower than similar treasury securities without the inflation protection. Other disadvantages include:

• Taxes: You are liable for federal taxes on the inflation adjustment unless you use these securities in a tax-deferred or non-taxable account.
• Tradability - TIPS aren't as easy to trade on the open market as non-indexed treasuries.
• CPI Calculation - Many Economists, including Greenspan, feel the CPI is overstated. If the government decides to switch to a Chain-Weighted CPI, then the inflation adjustment won't be as valuable.
• Deflation - If the U.S. economy suffered from deflation, then these securities wouldn't be very useful.

Are They Worth It?

One way to calculate the possible advantage is to take a look at the average maturity of a 10 Year Treasury (4.3 % for example) and subtract the average maturity of a 10 Year Treasury Inflation Protected Security (2.5% for example). Once you get this number, you will know what inflation must be for the next ten years in order to make the purchase worth it.

If you seek an absolutely safe investment for your tax-deferred account and worry about increases in inflation, then Treasury Inflation Protected Securities might be the right choice for you.