A Dandy Inflation Hedge

Two types of Treasury debt offer you peace of mind

Fear of inflation is roiling markets again and making investors increasingly nervous. Higher prices are cropping up in many sectors of the economy, and the Federal Reserve is widely expected to hike short-term rates several more times this year. To take out an insurance policy against an inflationary outburst, investors should investigate the Treasury's two kinds of inflation-protection debt securities: TIPS, designed for investors, and Series I Bonds, a new kind of U.S. savings bond.

I Bonds provide a guaranteed real yield (over the inflation rate) of 3.4%. Real yields on TIPS, or Treasury Inflation-Indexed Securities, are even more alluring: 4.3% on the 10-year maturity, and 4.1% on the 30-year bonds. "They're cheap," says Jane Wyatt, principal at North Shore Advisors, a fixed-income firm in Minneapolis.

Introduced in 1997, TIPS pay a coupon, or interest rate, just like an ordinary bond. But the security's principal value is adjusted twice a year to reflect inflation, as measured by increases in the consumer price index. Take the example of a $1,000 inflation-indexed bond with a 4% real rate of return. If inflation were 1% during the first six months of the year, the principal would be increased to $1,010. And instead of receiving a semiannual interest payment of $20 (half of 4% times $1,000), the payment would be $20.20.

Real yields of 4% or more are historically fat. In the past half century, real yields on regular Treasury bonds have averaged only 2.3%. Those on U.S. corporate bonds have averaged some 3% since 1873. "The real yields [on TIPS] are higher than all the long-term analysis says they should be," says Alan Kral, vice-president at investment management firm Trevor, Stewart, Burton & Jacobsen. Adds Scott Grannis, chief economist at Western Asset Management, a Pasadena (Calif.) fixed-income firm: "You buy TIPS not because you are afraid of inflation. You buy them because the level of real yields is extremely attractive."

MARCH IN LOCKSTEP. TIPS also help diversify your holdings, which reduces investment risk and increases the odds that you'll earn a decent return over time. The trick is to put your money into assets that don't march in lockstep. The correlation between TIPS and other fixed-income securities is relatively low, says a recent Merrill Lynch study.

Although some $106 billion in TIPS are outstanding, the buyers have been chiefly institutions; TIPS haven't been a big hit with individuals. A problem: You have to pay taxes on your inflation-adjusted increase in principal each year, before you ever get any of your money at maturity. That's why these bonds work best in a tax-deferred savings account, such as an individual retirement account or a 401(k) plan.

You can buy TIPS on the open market or at auction through the popular Treasury Direct program (www.publicdebt.treas.gov; 800 943-6864). Several mutual-fund companies also offer inflation-indexed funds that invest in TIPS, including PIMCO's Real Return Bond Fund and American Century's Inflation-Adjusted Treasury Fund.

The I Bonds, introduced a year ago, are proving considerably more popular. Individuals have so far bought $700 million worth. Indeed, I Bonds account for 73% of the Treasury's online sales of savings bonds. I Bonds are different from TIPS in that the interest accrues, and you pay no taxes until you cash out.

The interest has two components: a fixed 3.4% rate, and an inflation adjustment, made twice a year and based on the consumer price index. Until the next reset on May 1, the inflation component is 3.52%. So the total interest earned is 6.98%. I Bonds keep paying interest and compounding for 30 years. If you redeem them within the first five years, though, you pay a penalty: three months of yield. But if you can sock them away for the long haul, they're a worry-free way to protect some money against inflationary erosion.

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