It seems like Treasury Inflation-Protected Securities are getting a lot of attention in 2012, and a lot of the attention isn’t positive. Then again, we’ve been hearing dire predictions for Treasuries in general for well over a year. But I do think that some of the current criticism is valid enough to consider when you are making investing decisions.

Dividend hunt? MarketWatch.com has an article titled ‘Why dividend stocks top TIPS for income investing‘, which lays out the pluses and minuses of the two investments:

… one income strategy is capturing the attention of investors and investment advisers alike: Swapping inflation-protected Treasurys, or TIPS, for dividend stocks yielding 3% or more.

“When someone says ‘I need more yield,’ my response is ‘You mean you need more risk in your portfolio,’” said Larry Swedroe, director of research for Buckingham Asset Management, LLC. “A dividend-paying strategy isn’t necessarily a bad one, but it’s much riskier. It’s not a substitute for fixed-income.”

… If inflation stays in a 1%-3% long-term range, dividend stocks should outperform TIPS, said Rob Arnott, chairman of asset manager Research Affiliates LLC and an expert in asset allocation.

But if inflation spikes, he noted, then stocks will get hit and even a fat dividend yield won’t offset the loss of capital.

Good article. I am a fan of dividend-paying stocks, really solid companies that have been steadily increasing their dividends. But those stocks are for the ‘risk’ portion of my portfolio, not for the ‘safe’ portion. Current super-low interest rates are forcing investors to look at riskier investments, and that is partly the reason stocks and commodity prices have been increasing. Does moving money out of safety and into risk make sense, especially with the stock market hitting multi-year highs?

For example, here is a one-year chart for a stock I own, a fairly boring (but solid) company in the food-service business. It pays a dividend of 3.4% and its stock price is up 7.2%, for a total gain of more than 10% — about the same as the TIP ETF last year.

Note the volatile path on the way to that 10% gain. This is a low-beta stock (0.64). This isn’t the picture I have in mind for my ‘safe’ investments.

Dire prediction for Treasuries. Bloomberg is carrying an article with the tantalizing headine, ‘Treasuries May Experience 20-Year Bear Market.’ It’s based on an interview with Paul Griffiths, head of fixed income at Aberdeen Asset Management.

Yields have fallen to historically low levels that are not justified by fundamentals … This makes the bond markets vulnerable to a sudden reversal. “Over time, and I’m talking about several years, bond yields may move dramatically. Our bias is towards a bear market, which may take 20-odd years to play out.”

Since Treasuries have been in a 30-year bull market, outperforming the stock market in that time, I can see the case for a reversal, with rates rising to ‘more normal’ levels, meaning higher than inflation for even short-term investments. If that happened suddenly, it would ravage the bond market (and probably the stock market, too). The Federal Reserve seems determined to keep short- and long-term rates low for the next two years, so the danger appears to be out in the future, but it is out there.

Warning from ‘the nation’s newspaper.’ You know a topic has reached its peak when USA Today weighs in on it. John Waggoner has an article titled, ‘The mystery: Why buy inflation-protected bonds?‘ He makes the case that TIPS prices have soared too high as interest rates have declined to record lows.

TIPS aren’t cheap right now. The yield on 10-year TIPS is -0.26%. At current yields, you won’t get enough interest to make up for the price of the bond. “We tell people that you have to be aware of what you’re buying,” Wright-Casparius says. “And you’re paying a premium at this juncture.”

If you think that inflation is going to rise sharply, TIPS will likely fare better than regular Treasury bonds. And if you buy TIPS from the Treasury and hold them to maturity, you won’t lose money. Even so, with rates so low, the big mystery will be how you’ll make much money with TIPS.

That’s actually a fair analysis. I think anyone buying TIPS today and expecting the out-sized gains of recent years is going to be disappointed. TIPS have become a ‘capital gain’ investment, instead of a super-safe source of inflation protection and income. If you buy and hold TIPS, they are really boring. They are the ballast of your portfolio, not the rising star.

A positive view. Larry Swedroe, a TIPS proponent, has an article on MarketWatch titled, ‘Time to slay these myths about TIPS.’ If offers the counter view that inflation protection makes TIPS an essential investment, and less volatile that nominal Treasuries:

Because TIPS fully hedge inflation, you can extend their maturity and earn the term premium without taking inflation risk. This is an important point many seem to miss. TIPS also have lower expected volatility than conventional Treasury bonds of the same maturity due to lower sensitivity to nominal interest rate movements.

Swedroe’s argument is primarily that TIPS are preferable to traditional Treasuries, even when they have a negative ‘real yield’ (after inflation). He makes the point that Treasuries also have a negative real yield against expected inflation, but no protection against unexpected inflation. He also recommends looking at the PIMCO 1-5 Year US TIPS Index Fund (STPZ) for investors worried about a future rise in interest rates.