Inflation-indexed bonds are the holy grail of income investing: limited volatility and a guarantee that your fund won't get ravaged by high inflation.

The value of an inflation-indexed bond rises with inflation, and inflation's something that's almost as certain as death and taxes. Conversely, an inflation-indexed bond's value can fall in a deflationary climate, but not usually below the bond's face or par value. Inflation-indexed bonds won't perform very well when inflation looks tame and conventional bonds are zooming up in price, but that diversification effect is part of the appeal.

Most funds focusing on inflation-indexed bonds stick with the highest quality, or those issued by the U.S. Treasury, which are commonly referred to as TIPS. There are also a small number of other bonds issued by government agencies and corporations that try to keep pace with inflation.

At the end of 1999, there were only a handful of dedicated inflation-indexed bond funds out there, including PIMCO Real Return PRRIX and American Century Inflation-Adjusted Treasury ACITX. But in recent years investors have clamored for these types of securities, spawning a host of other offerings which hope to ride the TIPS wave.

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