A New Leader In The Bond Derby?

With Wall Street pundits fixated on deflation, the idea of buying Treasury bonds that protect you against inflation seems as crazy as preparing for a communist takeover. But guess what? Treasury Inflation-Indexed Securities are actually a great deal right now. Even if the consumer price index rises only 1.7% annually over the next three decades--a mere tenth of a percentage point above the current rate--buy-and-hold investors will be better off with 30-year inflation-protected securities, commonly known as TIPS, than with conventional Treasuries.

If inflation rises more, not an unrealistic assumption given that the CPI has gained an average of 3.1% a year since 1926, TIPS would be an even better buy. Indeed, long-term bond prices have fallen while yields have risen almost a half percentage point since Jan. 1 amid worries over a hot economy, tight labor markets, and resurgent oil prices. But TIPS, which work by indexing the principal for inflation, have rallied. That may spur interest at the government's next auction of 30-year TIPS, tentatively slated for Apr. 15.

TIPS have yet to catch on with individual investors, who have bought only a fraction of the $75 billion issued so far, says Dan Bernstein, research director at Bridgewater Associates, a Westport (Conn.) money manager. Individuals have shied away from TIPS because they're hard to understand and less liquid than ordinary Treasuries.

Slowing inflation has also given people a reason to stay away. If you buy a conventional $1,000, 30-year bond at today's 5.5% rate, you are guaranteed $55 in interest payments each year, no matter what the inflation rate is, until you get your principal back in 2029. Let's say you buy TIPS, now yielding 3.9% plus an adjustment for the consumer price index, and inflation falls to 0.5% from the current 1.6%. Because of the lower inflation rate, you'll get only $44 annually. Nevertheless, even if the economy falls into deflation, you'll get the face value of the bonds back at maturity.

LESS VOLATILE. But if inflation spikes up, TIPS would outshine conventional bonds. For example, a $1,000, 30-year TIPS with a 4% coupon would yield $40 in its first year. If inflation rises by three points, your principal would be worth $1,030. The $30 gain plus the interest would translate into a 7% total return.

TIPS are attractive for another reason: They're one-quarter to one-third as volatile as conventional Treasuries because of their built-in inflation protection. So investors who use them are less exposed to risk, says Christopher Kinney, a manager at Brown Brothers Harriman. As a result, a portfolio containing TIPS can have a higher percentage of its assets invested in stocks, potentially boosting returns without taking on more risk.

Even so, the price of TIPS can change. If the Federal Reserve hikes interest rates, they'll fall. If it lowers rates, they'll rise. That won't be a concern if you hold the TIPS until maturity, of course.

If you're sold on TIPS, you can buy them without commission, with a minimum order of $1,000, at auction via the TreasuryDirect program (www.publicdebt.treas.gov, or 800 943-6864). You can also buy them, for a fee, through a broker or bank. If you don't want to hold individual securities, three mutual funds buy inflation-protected debt. They are Pimco Real Return Bond fund, 59 Wall Street Inflation-Indexed Securities fund, and American Century Inflation-Adjusted Treasury fund. The first two invest at least 65% of their assets in U.S. and foreign inflation-protected securities, while American Century is wholly in U.S. issues.

As with zero-coupon debt, it's best to hold inflation-protected assets in a tax-deferred account, such as a 401(k) or individual retirement account. That's because holders of TIPS have to pay federal taxes on the annual interest and the amount by which the principal is increased for inflation--even though they won't see a dime of the latter until the bond matures or is sold. Mutual funds have to pay out the interest and any inflation adjustment in the principal but are still best suited for tax-deferred accounts to take advantage of the compounding of interest and principal over time. If you're more concerned about inflation than deflation, take advantage of Treasury Secretary Robert Rubin's pet project. But take care to keep your gains away from Uncle Sam for as long as possible.

Before it's here, it's on the Bloomberg Terminal.