Inflation-protected bonds offer a tempting promise in an uncertain world, but some buyers are getting less protection than they think.

The tradeoff with these bonds is that yields are much lower than those of conventional bonds, but the principal is hitched to a broad index of consumer prices. If inflation roars, the bondholder's buying power keeps up.

That's the theory, at least. The reality is that each person will experience different cost changes in coming years because each person buys different things. There's no such thing as a bond that can protect every investor's buying power.

To see why, consider the largest issuer of these bonds: the U.S. government. It had $705 billion in Treasury Inflation-Protected Securities, or TIPS, outstanding at the end of September. So popular are these bonds at the moment that yields on 10-year ones are below one-quarter of one percent. (Last month, they briefly turned negative.)

 

Experts Explain: I-Bonds vs TIPS

2:27

Both Treasurys protect against inflation. What's the difference?

TIPS pay interest twice yearly, like regular Treasurys. In addition, their principal is adjusted according to changes in the Consumer Price Index, which tracks the cost of hundreds of categories of goods and services. And because interest payments are based on adjusted principal, bondholders get higher payments as consumer prices rise.

But even the CPI's caretakers at the Bureau of Labor Statistics are frank about the measure's limitations.

"An individual's inflation rate can be quite different from what the CPI shows," says Ken Stewart, a BLS economist. "If your family spends a lot on gasoline, the index might understate your cost increases over the past year." The CPI has increased by 3.9% over the past year, while its gasoline component has increased by 33.3%.

To compile the index, the BLS must make weighting judgments based on data showing how consumers spend. Consider the make-up of the CPI-U, a version of the index modeled on urban consumers and used as the TIPS benchmark. (If a reporter refers to the inflation rate without specifying, he probably means CPI-U.)

A senior with a heart condition might wonder why prescription drugs have a weighting of just 1.25%. Parents of college students will shake their heads at the notion that tuition and fees are 1.5% of spending. And don't try to tell a barfly that "alcoholic beverages away from home" are just 0.44% of his budget. Price hikes for these categories might be higher or lower than those for the broad index in coming years. There's no telling which consumers will be more inflation-prone and which will be inflation-resistant.

There are two other problems with TIPS. The first is that, in effect, most American investors are already loaded up on this asset class, whether they realize it or not. Social Security provides retirees with a lifetime of CPI-indexed payments. What's that, if not a giant inflation-indexed security?

The second problem is that inflation might meow rather than roar in coming years, leaving TIPS investors with meager returns. The one-year CPI change (3.9%) is less telling than the six-month change, because cost growth is cooling, according to Gary Thayer, chief macro strategist for Wells Fargo in St. Louis. It peaked at an annualized rate of 5.1% in May but is just 3.1% now. Mr. Thayer expects inflation to slow to 2.5% over the next year.

One way of forecasting the inflation rate is to subtract the TIPS yield from the yield for conventional Treasurys. In theory, this "breakeven rate" is equal to what buyers of conventional Treasurys expect for inflation. On 10-year bonds it works out to about 2% a year now. The Cleveland Fed says the breakeven rate isn't always reliable and that it has a more robust model for forecasting inflation, but its 10-year projection is almost the same: 1.9% as of Thursday.

All of that leaves today's TIPS buyers at risk of getting the best of neither world: slim returns if prices stagnate and imperfect protection if prices jump. As an alternative, investors might want to fight inflation the old-fashioned way, by simply trying to maximize returns using a mix of stocks, higher-yielding bonds and real assets.

Mr. Thayer suggests dividend-paying stocks. "Companies can raise their dividend payments over time, which helps long-term shareholders beat the inflation rate," he says. With economic uncertainty high, it's important to take a balanced approach and not bet too heavily on either defensive stocks or "cyclical" stocks that outperform when the economy expands, he says.

One way to gain broad exposure to such stocks is with the SPDR S&P Dividend ETF (SDY), which holds shares of blue chip firms that have increased payments for many years. It yields 3.4%.

Corporate bonds offer another option. High-quality ones should outperform Treasurys in coming years because of their higher yields, says Mr. Thayer. For example, the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which holds investment grade bonds with an average maturity of just over seven years, yields 3.9%, double what comparable Treasurys pay.

For braver investors, lower-grade "junk" bonds pay much more. The iBoxx High Yield Corporate Bond Fund (HYG) yields 8.3%. Junk bonds can offer hidden inflation protection because just as inflation can weaken savers it can strengthen debtors, giving a lift to junk bonds. But junk tends to tumble when the economy worsens, so wait for signs of improvement before buying, says Mr. Thayer.