A Bond Anybody Can Love

On top of their yield, these Treasuries offset inflation's bite

When a bright guy who is renowned as a longtime bull on stocks recommends a bond, I listen. That happened recently when Jeremy Siegel told Business Week that he finds a particular sort of oddball bond to be an attractive hedge against stocks. Siegel, the Wharton School economist whose book, Stocks for the Long Run, underpins today's buy-and-hold-equities creed, turns out to love a crazy little thing called TIPS.

TIPS is a nickname for Treasury inflation-protected securities, never mind that Uncle Sam's official name for these bonds is Treasury Inflation-Indexed Securities. Just that much gives you a clue how quickly the world of TIPS turns arcane. That's too bad, because the essence of these things is not that hard to grasp. In any case, I promise you'll be hearing more about TIPS soon.

GUARANTEES. One reason is that mutual-fund giant Vanguard Group is opening its new Vanguard Inflation-Protected Securities Fund, which is devoted to these bonds. A bigger reason is that inflation seems to be picking up. That's bad news for holders of both stocks and bonds--but not TIPS, which are built to withstand inflation via two unusual guarantees.

How do they work? First, in exchange for borrowing your money, the Treasury gives you a TIPS and vows to make up any purchasing power it loses to inflation. If the Consumer Price Index rises, say, 3% a year over the time you hold the bond, the Treasury will pay you that much extra on your principal when it matures. Ordinary bonds pay back only the face amount.

Second, the Treasury promises to keep you whole if deflation--a falling CPI--were to prevail while you held a TIPS. That sets a floor, guaranteeing that the bond's value will not fall below its face value if consumer prices drop.

Not bad. Yet these bonds are hardly a hot investment. Since coming out in January, 1997, they've claimed only a small slice of the total bond market. One drawback is they come in just seven maturities, ranging from 2 to 29 years. A bigger problem is taxes: Buy a TIPS, and you'll have to pay income tax each year on the inflation adjustments, even though you won't get the actual cash until the bond matures. That makes TIPS most useful in tax-deferred accounts. Hurting demand even more is that TIPS just don't appear to pay enough. The guaranteed interest TIPS must pay looks low next to ordinary bonds. A 10-year TIPS recently yielded 4.2%, while a plain 10-year Treasury bond yielded 6.3%.

REAL YIELD. The thing is, that gap is an illusion. If consumer prices rise by their long-term average of 3%, then the real yield of the ordinary Treasury bond, after inflation, sinks to 3.3%. The yield on TIPS? It holds steady at 4.2%. So, unless inflation stays far under its long-term average, that's a sweet deal.

For all the beauty at the heart of TIPS, though, their complexity makes them hard to love. A few Web sites I've found (table) help cut through the confusion and explain the details. There also are TIPS mutual funds, which offer an important edge: Thanks to a regulatory quirk, they can pay you, in cash, the inflation adjustment each year that you otherwise wouldn't see until the TIPS mature. Two TIPS funds, Pimco Real Return Bond and American Century Inflation-Adjusted Treasury, have operated since 1997, but the new Vanguard fund is a better bet because its annual operating expense is just 0.25%, cheaper by half or more.

A bull on stocks such as Jeremy Siegel would never suggest putting all your money in TIPS. That would sacrifice the higher long-term return on stocks, which after inflation he puts at nearly 7% a year. Yet stocks' returns over the next few years could be a lot lower--negative, even, as we've seen so far in this new millennium. Meantime, Siegel observes, the 4% return on TIPS "as a guaranteed rate of return is certainly comforting." Does your portfolio need a little comfort right now?

Questions? Comments? Send an e-mail to barkerportfolio@businessweek.com or fax (321) 728-1711