The recent spectacular drop in oil prices has taken inflation expectations down with it, along with the returns on inflation hedges including TIPS, or Treasury inflation-protected securities.

While those securities, which are used to hedge the risk from rising prices, have posted measly returns this year, most of the bloodletting could be over.

TIPS have gotten crushed, said Bret Barker, portfolio manager of Treasuries at Metropolitan West Asset Management in Los Angeles. TIPs are doing their usual seasonal dance in the fall, although this time around we are having a harder fall due to the energy correction, he added.

So far this year, the Lehman Brothers total TIPS return index is up 1.80 percent, underperforming the bank's total Treasuries index, which has posted 2.34 percent in total returns.

The proximate cause for the performance in TIPS has been the dramatic drop in crude oil . Prices have fallen by 20 percent after hitting a record high above $77 per barrel in mid-July. The average price of a gallon of gasoline, meanwhile, was $2.33, on Friday, down 49 cents a gallon from one month ago, according to the motorists' group AAA.

Some economists and strategists believe investors could be overexposed to securities and funds that guard them from inflation. Funds designed to hold precious metals have accumulated $3.5 billion this year while oil-sector funds are among the year's top asset gainers, with the Merrill Lynch Oil Service HOLDRs Trust amassing about $900 million this year, according to data tracked by Thomas McManus, chief investment strategist at Banc of America Securities in New York.

Since its May peak, the Reuters Jefferies CRB index, a basket of 19 commodities futures, has slipped 19 percent. The CRB index includes futures in everything from frozen concentrated orange juice to gold to oil and natural gas.

There are few signs of disillusion despite the sell-off since May, said McManus.

Indeed, the Standard & Poor's 500 Select Energy fund has attracted about $900 million this year through Wednesday, but suffered heavy redemptions on Friday of $500 million, added McManus.

With U.S. large-cap stocks benefiting from receding inflationary pressures, owing to declining oil and gasoline prices, investors need to consider whether their portfolio allocations are overweighted in inflation beneficiaries; we think many are, said McManus.

TOUGH YEAR FOR TIPS

Investors in TIPS have been hurt by the recent slump in oil and commodity prices, as expectations of future inflation rates have dropped precipitously.

The break-even rate on five-year TIPS, a measure of the future inflation outlook, has collapsed by 40 basis points since August 7, when crude prices were trading at $76.98 a barrel, their second-highest ever close. Tuesday, oil prices fell to a seven-month low below $60, to $59.23.

But the more eye-popping movement has come in the break-even rate on TIPS maturing in January 2007, which has plunged to negative 1.68 percentage points from positive 2.27 percentage points in early August, said Michael Pond, interest-rate strategist at Barclays in New York.

The bottom fell out of the TIPS product, said Barker.

As with a traditional bond, the semi-annual coupon rate on a TIPS issue is fixed. TIPS' principal is adjusted annually to reflect the erosion of its value from inflation; thus the bigger the rise in the Consumer Price Index, the bigger the increase in TIPS' principal.

I think headline CPI drops and that is what you get paid on, said Barker, adding that he thinks TIPS are fairly valued. I would consider adding them if they cheapen. Right now the break-evens are pricing in very weak CPI readings already, and should do better going into the end of the year.

Pond of Barclays said 10-year TIPS are attractive at a real yield of about 2.30 percent and is much less sensitive to price swings in oil and gasoline prices.

Crude oil Inflation