"TIPS :: Treasury Inflation Protected Securities -- the Disadvantages"

What are the disadvantages of TIPS

Treasury Inflation Protection Securities do have one big disadvantage -- taxes.

Even though the principal of TIPS bonds increase, you do not receive any of that money until you realize the increase in principal. That is, when you either sell the bond or redeem it upon maturity.

In other words, until maturity, TIPS interest is NOT money in your pocket

However, the government considers this addition to your principal to be taxable income. The tax code does not distinguish between real (received) and nominal (on paper only) income.

So . . . although no money from the increase in principal goes into your pocket, you must pay taxes on it.

Now, before you rear up and spit . . . think of it this way -- you're saving money on a continuous basis.

Many people add money to their mutual funds every year, and still have to pay taxes on capital gains incurred and dividends or interest received by the fund, even though they choose not to withdraw any money from the account.

A TIPS owner is simply putting money aside . . . by sending it to the IRS

Not the usual way you invest, to be sure, but remember that the entire increase in principal of your TIPS bond is still yours.

The other disadvantage of TIPS is that the coupon rate of interest is lower than many other bonds, treasuries or other investments.

It's not likely, but it's possible that you could buy a TIPS, then the high economy has higher interest rates and very low inflation. You could earn less than if you had simply bought a regular Treasury bond.

The stock market returns an average annual return of 10%

Of course, the stock market returns include capital gains/share price appreciation -- which you can't spend until you sell the shares of stock . . . the great Catch-22 the financial gurus fail to point out.

So for income investors the real concern is with the dividends paid by stocks. Right now, the average dividend paid by S&P 500 companies is only u%, quite a bit less than what TIPS pay.

However, some companies pay much larger dividends.

And if you choose good companies, they will continue to increase their dividends. Most will start off paying you less than the interest rates on TIPS bonds. But over time they will eventually pay much more than that.

And again, if your choose good businesses, they will grow their earnings faster than inflation.

Next: What are the advantages of TIPS

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