Interest in Treasury Inflation Protected Securities (TIPS) is surging as investors seek protection against both inflation and deflation. Even Yale endowment manager David Swensen, in an interview conducted in late May, recommended TIPS, saying they offer unique advantages under a broad range of economic scenarios.

For U.S.-based investors seeking protection for retirement assets, there is no better investment than TIPS. Retirees can park their assets in TIPS and, if their account is large enough, maintain their standard of living on an inflation-protected basis.

But TIPS are not without risks, and those risks are typically not well understood by investors. TIPS, as we will see, are among the most volatile of fixed-income securities.

TIPS, which were introduced to the U.S. market in 1997, guarantee a real rate of return to the investor. They carry a coupon rate and, each month, the principal value of the security is adjusted based on changes in the CPI-U, either up if there is inflation or down if there is deflation. Payments on TIPS are calculated by multiplying the coupon times the adjusted principal value.

The principal value of TIPS is protected at par at maturity. In a deflationary period, the principal value may go below par, reducing interest payments to investors, but at maturity the investor is guaranteed payment of the full principal value at par.

TIPS represent a relatively small portion of the U.S. Treasury market, with $14 billion issued in the second quarter of 2009 as compared with $327.5 billion in nominal bonds.

Boston University Professor Zvie Bodie argues that TIPS are the safest inflation hedge for a U.S. dollar-based investor and are arguably the safest investment in the market today–period. All other traditional inflation hedges may work as a hedge, but will introduce other risk factors. TIPS, on the other hand, are a pure inflation hedge.

If real interest rates are stable, TIPS will trade near their accrued principal value. But real interest rates have been relatively unstable, and TIPS prices have fluctuated substantially. The chart below shows the market price (in red) and accrued principal value (in blue) for a 30-year TIPS issued on 4/15/98.

The market price fluctuated between 89.3 and 135, with a range of more than 30 points in 2008. Although the price is above the principal value roughly as long as it is below this value, the volatility is substantial.

The culprit behind this volatility is the long duration of TIPS. Duration is a measure of the sensitivity of a bond’s price to changes in interest rates; bonds with longer duration have greater price changes in response to a given change in interest rates. Duration increases for bonds with cash flows farther in the future. Because TIPS have a substantial principal payment at maturity, they have long durations.

Another source of volatility is the instability of real interest rates. Real and nominal interest rates generally move in tandem, but can diverge during unstable periods. Real interest rates spiked up in the fall of 2008, causing a decline in TIPS’ value, despite inflation during most of this period.

In an inflationary environment, bond investors, faced with rising nominal interest rates, demand higher risk premia, causing real interest rates to rise. These investors will also find TIPS a more attractive asset class, and supply and demand imbalances will push down real interest rates. One cannot forecast which force will be more dominant if inflation escalates.

TIPS priced at a discount are less risky than TIPS priced at a premium. This asymmetry is due to their principal protection at maturity. In a deflationary environment, this protection offers greater benefits to TIPS priced at discount; in an inflationary environment it does not matter. Our Treasury Department seems to have figured this out, and has recently been auctioning TIPS at a premium, by re-opening existing issues. The bond market has figured this out too: TIPS priced at a premium generally have higher yields, to compensate for the additional risk.

Investors can buy individual TIPS from the U.S. Treasury with no transaction fees, or they can buy one of two TIPS ETFs– Barclays’ iShares TIP and State Street’s IPE. The two ETFs are similar, with nearly identical performance records, expense ratios, and average maturities.

The crucial difference between individual bonds and ETFs is that TIPS ETFs increase their monthly distributions above the level of monthly coupons to equal the amount by which their principal value accrues. This eliminates the “phantom tax,” making them preferable for tax-sensitive investors.

In an inflationary environment, owners of individual TIPS are taxed on interest payments and the increase in principal value of the bonds. The latter gives rise to the phantom tax, since no income is received on this principal accrual. The phantom tax is often cited as a disadvantage to owning individual bonds. However, research has shown that TIPS offer ex-post after-tax yields equivalent to those of nominal Treasury bonds. If investors have the cash to pay the tax on TIPS, they are no worse off owning them.

Investors funding retirement accounts should own TIPS with maturities that match those of their liabilities or more precisely, with durations that match those of their liabilities. Therefore, individual TIPS are preferable to ETFs, which have a constant maturity and duration.

Ideally, TIPS should be held in a pension fund or other tax-sheltered account, eliminating the phantom tax issue and facilitating the ownership of individual bonds.

Remember: TIPS are volatile, and are best suited for investors who can hold them to maturity.

Robert Huebscher, rhuebscher@advisorperspectives.com, is CEO of Advisor Perspectives (www.advisorperspectives.com), a free online database and weekly newsletter for wealth managers and financial advisors.