Q. I'm a risk-averse 81-year-old widow who has been investing in Treasury Inflation Protected Securities (TIPS). My most recent tax statement shows the principal declined. Now I am questioning if these bond investments are what I should be holding. Ferne F., Kailua

A. It's difficult to answer this question without knowing more about your situation and your financial goals.

But maybe by taking a look at the reason why you bought the securities and a little background information on why the principal shrank can shed some light on the issue.

First, TIPS are favored by some retirees because they offer a hedge against inflation while providing an investment vehicle that's backed by the full faith and credit of the U.S. government. Some people say TIPS are among the safest investment vehicles around, though the returns aren't exactly setting the barn on fire.

These bonds debuted 10 years ago and are available in $1,000 increments. Here's why they're attractive to risk-averse folks: Unlike traditional bonds, the principal ($1,000) rises as inflation rears its head.

So someone plunking down $1,000 now probably won't just get back that amount 10 years from now. She'll get the $1,000 plus any adjustment because of inflation.

For simplicity sake, say over a certain period inflation rises 10 percent. The principal is now $1,100, or $1,000 of the original investment, and $100 for the 10 percent inflation adjustment.

The consumer price index for urban consumers is noted at the time of the sale, and all subsequent increases or declines in the CPI-U are used to figure out how much principal you've got. This adjusted figure is used for tax purposes, but more on this later.

Interest payments on the inflation-adjusted principal are made twice a year. There's extensive information about inflation adjustments and ratios used to calculate principal, as well as general information about TIPS, on the www .treasurydirect.gov Web site.

The site will spell out the inflationary attributes of TIPS.

But it also includes a note that principal can decrease if the CPI-U declines.

While the Treasury Department guarantees the principal payout will never be lower than the original $1,000, the inflation-adjusted amount can decline if there have been declines in the CPI-U.

And guess what? The CPI-U was lower at the end of the year than during the summer because of falling gasoline, transportation and apparel prices.

Back to taxes.

Interest payments on TIPS are exempt from state and local taxes. Federal income tax must be paid on interest income. It also must be paid on any increase in the principal.

This last point is galling to some people because they have to pay on increases in principal even though they would get this back until the TIPS mature.

In your case, you paid taxes on the gains in principal in 2005. For 2006, you may be able to take a deduction for the decline in principal.

As for switching out of TIPS to some other investment, more information is needed. You'll want to talk with a trusted investment adviser or a certified public accountant who can help with financial planning. You'll need to discuss your income needs, investment goals and other investments.

Louis D'Avanzo, portfolio manager of the Hawaii Municipal Fund and the Hawaii Intermediate Fund, said he couldn't make recommendations about what you should do without knowing more. But he noted there are higher-paying bonds if producing income is a goal. The recent TIPS have been sold with interest rates lower than 3 percent.

"The downside is they don't pay a heck of a lot of interest," D'Avanzo said. Benchmark 10-year Treasury notes, also backed by Uncle Sam, yield around 4.8 percent.

TIPS "take away some of your risk, but they don't necessarily give you the most income right now," D'Avanzo said.

Risk-averse investors can also look at a well-run municipal bond fund that they don't have to pay commissions for, he said. Moreover, there is no forecast for huge inflation in the near future, D'Avanzo said.

"The investments kind of turned out to be a dud if you've held it in the past couple of years. Hindsight, of course, is a great way to look at things."

Do you have a question about personal finance, taxes or other money matters? Reach Akamai Money columnist Greg Wiles at 525-8088 or gwiles@honoluluadvertiser.com