These Bonds Looked Like Losers. They're Not

When the Clinton Administration un-veiled plans last year to offer "inflation-indexed" bonds, some Wall Street wags likened the proposal to peddling flood insurance in the desert. Indeed, with the Federal Reserve having apparently slain the inflation beast, many pros saw little need for the insurance the bonds would provide against a sharp surge in prices. And since these bonds were expected to offer a lower interest rate as the trade-off for the insurance, many experts recommended taking a pass.

But a funny thing happened after the government's latest auction of the inflation bonds: Thanks to Wall Street's cool reception, the 10-year inflation-indexed bonds now offer a real return almost as high as conventional Treasuries of the same maturity. And with recent economic reports suggesting that inflation may not be dead after all, some pros think the indexed bonds--which pay a fixed interest rate plus a sweetener pegged to the consumer price index (CPI)--are now worthy of a second look.

The $8 billion in indexed 10-year bonds auctioned by the Treasury Dept. on Apr. 8 were priced to yield 3.65%, in addition to the payment tied to the CPI--which, at a current 3% level, gives the bonds a total return of 6.65%. That's not only above the 3% to 3.25% real yield many pros expect as the market matures in coming years, but surprisingly close to the current 6.87% yield on conventional 10-year Treasuries, which--unlike their inflation-indexed counterparts--offer no hedge against spiraling prices.

"CHEAP INSURANCE." With the stock market vulnerable to a further slide, many experts suddenly are attracted to the prospect of locking in a guaranteed real return approaching 4%. That's better than the average 2.5% to 3% annual real return on bonds over recent decades and is creeping up on the 6% inflation-adjusted return of stocks during the same span.

What's more, with the government's producer price index for March showing signs that inflation pressures are building, some investment pros suggest that investors consider hedging their bets with the insurance these bonds offer. "As long as the insurance is this cheap, it may be wise to buy inflation-linked bonds," notes John Hollyer, a portfolio manager for Vanguard Group.

TAX QUIRK. Some pros think the real return could rise even more for buyers at the Treasury Dept.'s next auction, this summer. With the Federal Reserve widely expected to raise the federal funds rate from 5.5% to 5.75% at its May 20 meeting, the resulting pressure on long-term interest rates could raise the effective yield on the 10-year indexed bonds as high as 3.9%, says Daniel Bernstein, research director for Bridgewater Group, an investment firm in Wilton, Conn.

Despite the attractive returns, the inflation bonds aren't for everyone. Here's how they work: Twice a year, investors get checks based on the fixed interest rate of the bond. In addition, interest is accrued according to changes in the CPI but is not paid out until the note matures or is sold. However, taxes must be paid annually on the total change in the bond's value. That quirk alone may make them less attractive to retirees and others who need current income. Younger workers can defer these taxes, however, by holding the bonds in a 401(k) or other retirement account.

What's more, the bonds carry some political risk--namely, that Washington will revise the CPI downward as a way of reducing entitlement outlays. However, Clinton Administration officials vow that they'll protect investors from an arbitrary cut in the inflation payout, noting that such a move could trigger a loss of confidence on the Street. "We would pay for it many times over in our other auctions, and we can't afford that," says Roger Anderson, the Treasury's deputy assistant secretary for federal finance.

Investors who prefer the convenience of a mutual fund might want to keep their eye on the handful of inflation-indexed funds that have sprung up: American Century and Pimco have launched indexed bond funds, and Dreyfus intends to do the same. But Morningstar analyst Todd Porter recommends waiting another 6 to 12 months until the funds can better diversify. Although only 10-year inflation bonds are currently available, Treasury plans to introduce 5- and 30-year securities in the future. "At this point, I would just buy the bonds directly and avoid the management fees," advises Porter. You can buy the bonds through your broker or by ordering directly through the Treasury Direct program (202 219-3350). In a market like this, a little insurance never hurts.