Safe Investing in a Troubled Economy

Here are some of the safest places to invest your money. But the price of safety may be low returns

by Chris Farrell

Warren Buffett's mentor, legendary investor Benjamin Graham, wrote that when challenged "to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Those are wise words for all seasons, but especially at a time like this. Even after the Wall Street crisis dies down, households will remain under pressure to create their own margins of safety by saving more and borrowing less.

Places to stash cash and hedge against risks like inflation and a weak dollar range from plain-vanilla Treasuries to certificates of deposit denominated in euros. All of the options below rely on the backing of the U.S. government rather than private-sector promises.

SHORT-TERM TREASURY SECURITIES

The allure of safety was so strong late in the week of Sept. 15 that the yield on the three-month T-bill went negative at one point. That's right, below 0%. The yield is up, but investors are being paid less than 1% on their investment. That said, anyone tempted to go for a higher yield by buying the 10-year Treasury bond at 3.79%, or the 30-year at 4.37%, should think twice, with consumer inflation up 5.1% so far this year. "Treasury yields are stupidly low," says Robert Auwaerter, head of the fixed-income group at Vanguard Group.

TREASURY INFLATION-PROTECTED SECURITIES

The fear over rising prices is why more investors are flocking to U.S. Treasury Inflation-Protected Securities (TIPS). "The yield on long-term inflation-indexed bonds is around 2%," says Laurence Kotlikoff, head of the financial planning firm ESPlanner. "That's surely the place for those who must seek shelter from this storm." The bonds are available in 5-, 10-, and 20-year maturities.

TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. The bond's principal adjusts semiannually as the CPI changes. TIPS tend not to move in sync with other fixed-income securities, so they're a good diversifier. An additional advantage is that they protect against deflation, or a decline in the overall price level of goods and services. After all, Japan became known as Deflation Nation when its finance mania crashed in the late 1980s. Deflation also gripped the world economy during the Great Depression. TIPS offer a "deflation floor" that protects principal value if the fear of falling asset values turns into a deflationary episode. It guarantees the TIPS owner either the inflation-adjusted principal or the par value at maturity—whichever is greater.

TIPS have one drawback: taxes. In essence, Uncle Sam requires owners in taxable accounts to pay income taxes on inflation-adjusted gains before getting any of the inflation-adjusted money at maturity. The trick to avoiding the tax hit is to own the bonds in a tax-deferred retirement savings account. Most major fund companies and financial firms offer a TIPS fund, such as the PIMCO Real Return Bond Fund and the iShares Lehman TIPS Bond (TIP).

I BONDS

Taxes aren't an issue with I Savings Bonds, the federal government's other inflation-protected security. These 30-year bonds allow money to compound tax-deferred until they are cashed in. There are no commission costs. I bonds redeemed before five years forfeit the three most recent months' interest, but after that there is no penalty at redemption.

At first glance, the rate on I bonds seems to be a joke. The fixed rate on I bonds bought before November of this year is 0% (the rate is announced every May and November). Any gain will come from adjustments in the CPI. Earlier this year the Treasury Dept. cut deeply into how much you can put away in I bonds. Savers can now buy $10,000 worth—$5,000 at treasurydirect.gov and $5,000 in paper bonds at a bank.