The role that Treasury inflation-protected securities (TIPS) play in a diversified bond portfolio got a big boost in 2007. As many investors labored to eke out gains amid crumbling credit markets, the stars aligned for inflation-indexed bonds, and the Lehman Brothers TIPS index returned an impressive 11.7 percent.

If you buy a conventional Treasury, you receive the same interest payment semiannually for the life of the bond. With TIPS, the Treasury adjusts the principal value of a bond each month (with a two-month lag time) to keep pace with inflation. A higher principal value also lifts interest payments.

When pros compare Treasuries and TIPS, they study the break-even inflation rate. Recently, 10-year Treasuries yielded 3.8 percent, and 10-year TIPS yielded 1.6 percent. That implies a break-even inflation rate of 2.2 percentage points. If inflation over the next 10 years tops 2.2 percent annually, you'll do better with TIPS than with the equivalent Treasuries.

Fund managers such as Dan Shackelford of T. Rowe Price Inflation Protected Bond think strong demand from emerging markets will continue to push food and other commodity prices upward over the long haul. "A 2.2 percent break-even looks like an easy bogey to beat over 10 years," he says. Shackelford looks for TIPS to return 5 percent to 6 percent in 2008. Last year, his fund (symbol PRIPX; 800-638-5660) returned 11.1 percent. Over the past five, it gained 5.5 percent annualized, compared with 5.2 percent for the average TIPS fund.

The granddaddy of TIPS funds is Pimco Real Return Institutional, managed by John Brynjolfsson from its inception in 1997 until last December. The fund's minimum investment is out of sight, but with just $1,000 you can buy a virtual copy, the 2-year-old, Pimco-managed Harbor Real Return Institutional fund (HARRX; 800-422-1050), which gained 11.4 percent last year. Pimco's team invests some assets in foreign inflation-indexed bonds.

Another fine choice is Vanguard Inflation Protected Securities (VIPSX; 800-635-1511), managed by John Hollyer and Kenneth Volpert since its launch in June 2000. It's tamer than the Harbor fund and has rock-bottom expenses (0.20 percent per year); it returned 11.6 percent in 2007 and 6.1 percent annualized over the past five years.

How much to allocate to TIPS? Volpert suggests that retirees split Treasury holdings between conventional bonds and TIPS. Brynjolfsson says Pimco advises splitting a diversified portfolio into three categories: stocks, bonds and such assets as TIPS, commodities and real estate that help offset rising prices. "Bonds protect against deflation," he says. "TIPS protect against inflation."


Andrew Tanzer is a senior associate editor at Kiplinger's Personal Finance magazine. Send your questions and comments to [email protected]