"TIPS could be thought of as an insurance policy built to protect your invested assets' purchasing power," says Nathan Kubik, a Certified Investment Management Analyst at Carnick & Kubik.
Most individual investors purchase TIPS through a mutual fund or exchange-traded fund that owns a basket of inflation-protected securities with varying maturities.
That can be a smart move. For example, the Vanguard Inflation-Protected Securities Fund has averaged a return of 6.36 percent since its inception in 2000 through November 2013.
Meanwhile, in 2008 -- as stocks were melting down -- the Vanguard fund lost just 2.85 percent and quickly rebounded the following year with a 10.8 percent gain.
However, investing in a TIPS mutual fund carries risks. Changes in interest rates can cause the value of TIPS bonds within a fund to lose value. And when fund investors see their investments going the wrong way, they often head for the exits en masse. The fund manager is then forced to sell securities at precisely the wrong time -- when they're losing money -- creating even more losses for those long-term investors who stay in the fund.
This year hasn't been a stellar year for TIPS funds. Through the end of the third quarter of 2013, they lost an average of 6.3 percent year to date, according to Morningstar.
Buying individual TIPS
If you are squeamish about incurring losses over which you have no control, you may consider skipping a mutual fund and instead purchasing individual TIPS directly.
By doing so, you theoretically guarantee you will never lose a dime, so long as you hold the bonds to maturity.
TIPS can be purchased directly from the government via the TreasuryDirect website, but only if they are held in a nonretirement account. The Treasury issues TIPS throughout the year in maturities of five, 10 and 30 years. It periodically publishes an auction schedule that enables investors to plan such purchases.
Each month, the principal on your individual TIPS is adjusted based on the inflation rate as measured by the Consumer Price Index for All Urban Consumers, or CPI-U.
Zvi Bodie, a professor of finance and economics at Boston University, recently generated some buzz in personal finance circles by urging individual investors to consider purchasing individual TIPS rather than stocks as a cornerstone of their retirement planning strategy.
Bodie -- who has written extensively on pension management and retirement planning -- offered an expanded take on his argument in the book "Risk Less and Prosper: Your Guide to Safer Investing," co-written with Rachelle Taqqu.
But is the strategy wise?
If you have planned future expenses and know you will need a certain amount of money at a specific time, you may be a good candidate for buying individual TIPS, says Patrick Collins Jr., a Certified Financial Planner with Greenspring Wealth Management in Towson, Md.
"As with any investment, it is important to understand your goals and what you are hoping to accomplish," Collins says.
Kubik agrees that buying individual TIPS can make sense for some investors who seek a bit more certainty in their retirement outlook.
"Owning individual TIPS offers an investor the ability to place an inflationary hedge with a greater degree of customization," he says.
Rick Kahler, president of Kahler Financial Group in Rapid City, S.D., says individual TIPS make sense for people building a bond ladder to fund a specific goal.
However, he offers a couple of caveats to that advice.
"You need to consider taxes and the complexity of the bond," he says. "There is no bond more complex than a TIPS."
When TIPS are held in a nonretirement account, they are taxed annually in two ways: on their accumulated interest, and on the amounts that have been added to the principal as part of the inflation adjustment.
The latter levy is widely described as a tax on "phantom income," and it can result in a higher tax bill each year if you hold TIPS in a taxable account, says Wan-Chong Kung, a Minneapolis-based senior vice president and portfolio manager with Nuveen Asset Management.
"You will need to pay federal taxes on accumulated inflation that is used to increase your principal amount, even if you do not receive the principal adjustment until maturity," he says.
Because of how TIPS are taxed, most advisers recommend holding them only in a retirement account, where annual taxes can be deferred (as in a traditional IRA) or eliminated (as in a Roth IRA). The most practical way to purchase individual TIPS in an IRA is through a bank, a discount brokerage firm or a fund firm with a discount brokerage arm, such as Vanguard, Fidelity or Charles Schwab.
You can ask a broker to purchase individual TIPS on your behalf, although this often requires you to pay a fee. Many mutual fund firms also allow you to purchase these funds directly online, fee-free.
Kung also notes that the periodic interest payments associated with TIPS are not automatically reinvested. To keep these amounts inflation-protected, you will need to earmark them for the purchase of future individual TIPS.
Time to avoid TIPS?
Despite the potential advantages of purchasing individual TIPS in an IRA, Kubik says he is advising clients to avoid TIPS right now because inflation remains under control.
"If market conditions shift and we foresee high levels of inflation, (TIPS) could very well be one of the inflationary tools that we would use to create a hedge," he says.
Samuel Scott, president at Sunrise Advisors in Leawood, Kan., also is steering clients away from TIPS right now. He believes other asset classes -- including other currencies, commodities, stocks and real estate -- offer better inflation protection.
He sounds a note of skepticism about how the government calculates inflation for the purpose of adjusting TIPS principal.
"The cynic in us thinks the government has an incentive to calculate CPI in such a way that minimizes outlays," he says.
Scott notes that CPI calculations have been adjusted over the years, and that when the government makes cost-of-living adjustments, "there is financial incentive to understate true inflation," especially in light of payments tied to those adjustments, such as Social Security obligations.
If your faith in the government's inflation calculations is a bit stronger, but you want to skip the hassle of buying individual TIPS, you can still purchase a TIPS mutual fund or exchange-traded fund.
Collins says a TIPS mutual fund still makes sense for many savers and investors, especially those who want a "less hands-on approach."
TIPS funds and ETFs require less work than individual TIPS since you can set them up to automatically reinvest their periodic interest payments.
If you are worried about interest rates rising, be careful about the type of TIPS mutual fund you purchase, Kahler says.
"I currently like the short-term TIPS bond funds, especially in an environment where interest rates are rising," he says.
Most TIPS mutual funds hold bonds with long maturities. As interest rates rise, the value of these bonds falls, which can impact the fund's overall performance.
Purchasing a TIPS fund that holds bonds with shorter durations gives investors a measure of protection when interest rates climb.