FINANCIAL FOCUS: HOT TIPS ON INFLATION HEDGE

This "Financial Focus" column is prepared by Edward Jones Investments, with headquarters in St. Louis and local branches in Cape Girardeau and Jackson.

When you think about investment risk, what comes to mind? For many people, it's the chance of immediately losing money when their stock drops in value. Of course, that is one type of investment risk -- but it's not the only type.

For example, if you own bonds, you incur interest-rate risk -- the possibility that interest rates will move higher than the rate on your existing bond. No matter what happens to market interest rates, you'll still receive the same interest payments as well as your original principal back when your bond matures. However, if rates increase and you want to sell your bond before it matures, you will have to offer it at a discount, because no one will pay full price for a bond that carries an interest rate below the market rate.

There's another risk that's too often overlooked -- inflation. For the past several years, we've enjoyed low inflation. But it hasn't disappeared altogether. And the mere possibility of its re-emergence is enough to make some investors take action -- particularly if they've invested in fixed-income vehicles, such as U.S. Treasury securities.

Even a relatively mild inflation rate, such as 3 percent, can, over time, seriously erode the purchasing power of your Treasury bonds. That can be a real concern -- especially if you're counting on those bonds to help provide income during retirement.

What can you do to build a "hedge" against inflation? You might consider investing in U.S. Treasury Inflation-Protected Securities (TIPS). These bonds offer the security of U.S. Treasuries -- considered the least risky investments available -- along with a rate of return that can keep you ahead of inflation.

To understand how TIPS work, let's first consider how a "normal" bond operates. When you buy a bond, you receive interest payments based on the principal that you invested; that principal will be repaid to you upon the bond's maturity. The more inflation rises over the years, the less buying power your principal will have when it is returned to you.

When you buy a TIPS, you'll receive a guaranteed yield, just as you would with a normal bond. But on top of that yield, the principal value of your bond will actually increase in line with inflation, as measured by the Consumer Price Index (CPI). So, for example, if your bond paid 4 percent interest, and the inflation rate was 3 percent, you would receive an effective annual return of 7 percent. The inflation factor is adjusted periodically throughout the life of your bond.

Be aware that you'll have to pay income taxes each year -- both on the interest payments you receive and on the inflation adjustment, which you won't get until you sell the bond. Consequently, you may want to put your bond in a tax-deferred vehicle, such as an IRA.

Before you purchase TIPS, see your tax advisor to make sure these investments are suitable for your individual situation. If they are, weigh the advantages carefully: Guaranteed interest rates, government backing and the chance to beat inflation form a combination you won't find anywhere else.

The Southeast Missourian does not recommend that readers buy or sell stocks featured in this column, which is provided for informational purposes only.