.floatimg-left-hort { float:left; } .floatimg-left-caption-hort { float:left; margin-bottom:10px; width:300px; margin-right:10px; clear:left;} .floatimg-left-vert { float:left; margin-top:10px; margin-right:15px; width:200px;} .floatimg-left-caption-vert { float:left; margin-right:10px; margin-bottom:10px; font-size: 12px; width:200px;} .floatimg-right-hort { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 300px;} .floatimg-right-caption-hort { float:left; margin-right:10px; margin-bottom:10px; width: 300px; font-size: 12px; } .floatimg-right-vert { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 200px;} .floatimg-right-caption-vert { float:left; margin-right:10px; margin-bottom:10px; width: 200px; font-size: 12px; } .floatimgright-sidebar { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 200px; border-top-style: double; border-top-color: black; border-bottom-style: double; border-bottom-color: black;} .floatimgright-sidebar p { line-height: 115%; text-indent: 10px; } .floatimgright-sidebar h4 { font-variant:small-caps; } .pullquote { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 150px; background: url(http://www.dmbusinessdaily.com/DAILY/editorial/extras/closequote.gif) no-repeat bottom right !important ; line-height: 150%; font-size: 125%; border-top: 1px solid; border-bottom: 1px solid;} .floatvidleft { float:left; margin-bottom:10px; width:325px; margin-right:10px; clear:left;} .floatvidright { float:right; margin-bottom:10px; width:325px; margin-right:10px; clear:left;} Given the extraordinary fiscal and monetary measures taken by the federal government, the U.S. Treasury Department and the Federal Reserve Board in response to the failure of Lehman Bros. Holding Co. and the near credit collapse in early 2009, it is no wonder that there are budding expectations of inflation and higher interest rates.

The economy has been soaked with fiscal stimulus, interest rates are near zero and the U.S. greenback has depreciated relative to other world currencies, with the dollar index down 4.24 percent in 2009. With deflation seemingly avoided, there has been a surge of interest and buying in inflation-linked debt or TIPS (Treasury inflation-protected securities).

TIPS are U.S. Treasury securities designed to help protect investors from inflation. They can be purchased individually or through mutual and exchange-traded funds. Unlike traditional government bonds, the principal and interest payments adjust with changes in the Consumer Price Index (CPI). The inflation protection built into TIPS is designed to provide investors with predictable real returns from a set coupon and an explicit inflation hedge with principal adjustments.

In 2009, the total return for TIPS as measured by the Barclays U.S. Treasury Inflation Protected Index was 11.41 percent. In contrast, the total return for the 10-year U.S. Treasury note was negative 9.34 percent, which suggests inflation is on the horizon.

In addition, the difference in yield between 10-year TIPS and the 10-year Treasury note had widened to 2.45 percent at year-end 2009 from 0.08 percent in November 2008.

This difference is known as the break-even rate. The break-even rate is indicative of future inflation rates. When the break-even rate is less than the actual rate of inflation for the period to maturity, TIPS should provide a higher total return than conventional Treasuries of the same maturity, according to Bill Gross, the director of Pacific Investment Management Co.

It is interesting that higher interest rate expectations are growing despite statements from the Federal Reserve Board that tame inflation expectations are one reason for keeping its target interest rate in a record low range (in addition to high unemployment and low capacity utilization). The Fed has made it clear that it intends to keep the target rate low for an extended period of time.

Because TIPS have been around only since 1997, a period in which inflation has been constrained and interest rates reasonably low and stable, investors have not seen how they might perform during a real inflation spike or interest rate surge. The daily price of TIPS is affected not only by moves in the CPI but also by changes in interest rates.

Perhaps 2010 will be a year for intermediate and long-term interest rates moving higher while the CPI sees little change. In that event, it’s likely that TIPS will not perform as well as they did in 2009.

It should be mentioned that TIPS offer portfolio benefits in addition to the inflation hedge. Because TIPS tend to be less volatile than conventional bonds and clearly less volatile than equities, they provide the potential for enhanced capital preservation in a portfolio containing riskier asset classes. For this reason alone, they merit investors’ consideration.

Peter Percival is a registered investment adviser at Syverson Strege & Co. in West Des Moines.