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By Jason Stipp | 01-06-2011 05:54 PM

Inflation Protection Users Guide

Morningstar's Christine Benz highlights key considerations for potential TIPS, commodities, floating-rate fund, and stock investors.

Jason Stipp: I'm Jason Stipp for Morningstar.

You may have noticed at the gas pump or in a grocery store that certain prices on certain items have risen recently. Naturally this leads to fears of oncoming inflation and also ways that you might hedge against inflation in your portfolio.

Here with me talk about some common inflation tools, their pros and cons, is Christine Benz. She is director of personal finance for Morningstar.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, the first tool I think is the one that might to come to mind as the most obvious inflation protection, and that TIPS. And there are some important things to remember about how TIPS behave in order to use them effectively. What should you have in mind about TIPS if you're looking at them right now with some worries about inflation on the mind?

Benz: Well, you're right, they do have the most explicit inflation protection, so what happens with the TIPS bond is that you do get that bump up in your principal value as the CPI bumps up. So there is that explicit inflation hedge.

A couple of key things to keep in mind with TIPS right now is that they are pretty interest rate sensitive. We've not seen them stress-tested in a period of rising rates over many years, but what we have seen over short periods of time is a lot of interest rate sensitivity, not necessarily something you want, where the threat of rising rates looms large.

They are also a pretty tax-inefficient vehicle. So, to the extent that you hold them, you want to keep them within the confines of a tax-sheltered vehicle.

Stipp: So, I think it's an important distinction between the measure of inflation and the measure of interest rates, because they don't always move at the same time. We normally think, more inflation, higher interest rates, but you can see them move at different times, and that can cause some of the dislocation in what you might expect of TIPS performance?

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