Beating Inflation's Ills and Deflation's Chills

No matter which way prices go, investors aiming to protect retirement portfolios should consider two Treasury securities -- TIPS and I-bonds

Inflation, the scourge of savers and investors everywhere, is dormant. And in an intensely competitive global economy, with American business under relentless pressure to operate ever more efficiently, it's possible that prices will stay flat or even decline over the next decade.

The trend of the past 20 years has been toward price stability. The consumer price index (CPI) has been running at a 1.4% annual pace over the past 12 months ended in March, compared with a 3% pace the previous year. In the first three months of the year, the inflation rate as measured in gross domestic product, personal consumption expenditures, and the CPI slowed from the end-of-year pace in 2001. The first quarter's off-the-chart 8.6% surge in productivity will help stave off price pressures as the economy revives.

Indeed, there's a whiff of mild deflation in the economy, and the drop in prices is only partly driven by the recent recession. Thanks to global overcapacity in varied industries -- ranging from autos to semiconductors to telecom gear to major appliances -- consumers are paying less for many goods. Prices for retail goods, minus autos and gasoline, are falling at a 2% year-over-year rate. Excluding energy, import prices are down about 3.3%. Little wonder the Federal Reserve was in no hurry to change monetary policy at its latest Federal Open Market Committee meeting, on May 7.


  In this environment, investors might want to consider including Treasury Inflation Indexed Securities -- generally known as TIPS -- in the fixed-income portion of their portfolios. Many individual investors will find it cheaper and easier to purchase the Treasury's inflation-protected savings bond, the so-called I-bond. Like the mainstay Series EE savings bond, there are no commission costs for buying and selling I-bonds.

The appreciation on I-bonds compounds tax-deferred until they're cashed in, and they're exempt from state and local taxes, and also federal taxes if the earnings are spent on qualified educational expenses. TIPS and I-bonds are hedges against an untimely spike in inflation, say, around the time you're retiring. Even a low inflation rate of 1% to 2% will corrode a fixed-income portfolio over time.

Economists have long spoken in favor of bonds indexed to inflation. The U.S. government belatedly began issuing inflation-indexed bonds in 1997. America's Treasury is now the world's largest issuer of them, although Merrill Lynch estimates TIPS make up no more than 2.7% of gross Treasury issuance.


  Britain pioneered the modern market in 1981, and with good reason. Its average annual inflation rate from 1976 to 1980 was 13.6%, a price spiral that devastated the bond-heavy investment portfolios of domestic pension funds. Inflation-linked bonds accounted for some 20% of the British government's debt at the end of 2001, according to a recent Merrill Lynch report on the global bond market. Some 20 nations now sell these securities, usually benchmarked to a consumer price index.

U.S. investors have never truly embraced inflation-indexed securities. For one thing, the government started selling them at a time when investors were pocketing double-digit equity market returns and inflation was heading toward zero. Who wanted to own a bond with a real return of 4.4% in January, 2000, when the Nasdaq had soared by 65% and the Dow Jones industrial average was up 18% over the preceding 12 months? When the equity markets eventually did tank, investors remained somewhat cool toward TIPS, since inflation stayed so low.

Still, in a diversified portfolio, TIPS and I-bonds are valuable hedges against the risk the government will flirt with debasing the currency, perhaps over the decade or even a longer period. The Bush Administration's recent imposition of steep tariffs on imported steel -- and the subsequent surge in steel prices -- is an ominous portent of how swiftly any backing away from free trade can put upward pressure on prices.


  Unlike gold, the traditional haven against a debauched currency, owners earn interest from their bond investments instead of paying storage and other costs for a sterile asset. Of course, the return is hardly lush in a low interest rate environment. Investors in 10-year TIPS can lock in a real return of 3% for a bond maturing in 2010. The interest rate on an I-bond is now at 2.57%, down from 4.4% the previous six months.

Of course, in the case of sustained deflation, the principal value of these bonds will decline as the CPI falls sharply. But should the principal value fall below 100 cents on the dollar, the Treasury is committed to make up the difference when the bond matures, because the maturity value of the bond never falls below par. The same goes for I-bonds. Thus, these securities are not only hedges against rampant inflation but also against a steep deflationary spiral.

The bottom line: Whether you're an inflation optimist, as I am, or a pessimist, TIPS and I-bonds are a savvy way to preserve wealth.

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