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This hedge could protect your cash

TIPS still look underpriced by a key measure.

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Kristian Buus | In Pictures | Getty Images

If you ask investors about their biggest fears today, rip-roaring inflation probably wouldn't top the list. After all, prices have been sluggish for years, with the Consumer Price Index up only 1.1 percent over the last year.

But the winds may be changing: Several forces — including wage growth, a weaker dollar and a rebound in oil prices — suggest inflation could very well be on the horizon, and investors should pay attention.

Indeed, while demand for Treasury Inflation-Protected Securities (TIPS) has risen in recent months, the 10-year breakeven rate is around 1.6 percent, below both historical levels and the Federal Reserve's 2 percent target. The rate represents the difference between what conventional and inflation-linked 10-year Treasuries yield, and serves as a proxy for investors' inflation expectations.

In other words, it seems investors could be underestimating the risk of inflation.

While perhaps not as much of a steal as back in February — when the breakeven was 1.2 percent, the lowest it has been since 2009 — TIPS remain a good deal, said Morningstar fixed income analyst Brian Moriarty.

"TIPS are still looking cheap relative to history," Moriarty said.

The virtue of TIPS lies in their ability to preserve purchasing power by rising in value as inflation goes up. These government-issued bonds guarantee a certain coupon rate (currently about 0.15 percent for a 10-year TIPS, for example) and then adjust the principal or face value to go up or down with the CPI. While the coupon rate is lower than what Treasuries pay, the idea is that the inflation adjustment will make up for the difference — and then some, if prices really jump.

Now, not everyone agrees that today's investors need TIPS.

"For most people, the best way to protect against inflation is with a broadly diversified portfolio of equities," said New City, New York-based financial advisor Larry Luxenberg. "There don't seem to be huge inflationary pressures around the world right now."

If anything, there are deflationary pressures, Luxenberg said, pointing to the shortage of skilled workers. And unlike in the late '70s and early '80s, consumers today are not rushing to buy homes or apparel, which would be a signal that they expect prices to go up, he said.

But inflation doesn't need to shoot up by much to make TIPS a good bet, said Moriarty. Headline inflation actually went up in April relative to March, and core inflation sits at 2.1 percent. Core inflation, which doesn't include food and energy, tends to be a more stable measure of where inflation is headed, he said.

"Eventually inflation will come back," Moriarty said. "It always comes back."

Investors shopping for TIPS should heed one caution, Moriarty said. TIPS throw off "phantom income," meaning they are taxed each year they are adjusted upward for inflation.

"But you still won't see the money until the TIPS mature," he said.

For that reason, you're best off holding TIPS in tax-deferred or tax-exempt accounts like IRAs or Roth IRAs, he said.

And what if deflation rears its head?

One upside of TIPS is that they come with a "deflation floor": You are guaranteed to get back at least the original principal at maturity, even if prices fall.