The Beauty of Inflation-Proof Bonds

Beyond protection, TIPS offer solid returns

Investors yawned when Washington began selling inflation-indexed bonds in early 1997, a time when the stock market was going gangbusters and inflation was near historic lows. They have since picked up on the merits of Treasury Inflation-Indexed Securities, widely known as TIPS. A just-released report by Bridgewater Associates, a Westport (Conn.)-based investment management firm, shows TIPS gained 9.61% this year through July 22, one of the best-performing investments so far in 2002.

Demand has been so strong that the Treasury auctioned off $9 billion of 10-year TIPS on July 10, the largest sale of these securities ever. A day earlier, Fidelity Investments opened the ninth TIPS mutual fund launched since 1997. Assets in these funds, which include offerings by American Century; Brown Brothers Harriman; Pacific Investment Management; and the Vanguard Group, have increased 74% since January, to $7.4 billion at the end of June, according to Lipper.

As with an ordinary bond, TIPS pay a coupon, or interest rate. But the principal value is adjusted twice a year to reflect inflation, as measured by increases in the consumer price index. Say you pay $1,000 for a TIPS bond that carries a 3% coupon. If inflation was 1% during the first six months of the year, the principal would be increased to $1,010. Instead of receiving a semiannual interest payment of $15 (half the 3% times $1,000), the payment would be $15.15.

The eye-opener for many investors is that TIPS have proven to be relatively strong performers when inflation is mild, as is the case today. "People mistakenly thought they only needed inflation-indexed bonds if there was going to be 1970s-type [double-digit] inflation," says Dan Bernstein, director of research at Bridgewater Associates. "For TIPS to do well, inflation numbers only need to come in slightly higher than the market anticipates."

To figure out when TIPS are attractive, subtract the yield from that of a traditional Treasury security of the same maturity. In January, for instance, 10-year TIPS yielded 3.53%, vs. 5.29% for a 10-year Treasury note, resulting in a "break-even" inflation rate of 1.76%. That meant inflation needed only rise above 1.76% over the next decade for TIPS to outperform Treasury notes.

Since January, however, the CPI has defied expectations and risen from an annualized rate of 1.6% to 3%, causing TIPS prices to rise substantially. Today, the break-even inflation rate between 10-year TIPS and Treasury notes is 1.91%. Although TIPS are no longer cheap, Bernstein believes they remain a good deal because he sees the inflation rate staying at today's levels over the next few years.

Financial advisers steer investors away from buying TIPS simply to bet on inflation expectations. "The purpose of TIPS is not to try to make a killing but to preserve your real purchasing power over time," says Harold Evensky, a financial planner in Coral Gables, Fla. Evensky urges his clients to keep as much as half of their fixed-income portfolio in TIPS funds, with one caveat: They belong only in tax-deferred accounts. That's because you must pay tax each year on any principal increases although you don't pocket the money until the bond matures. The law requires TIPS funds, however, to pass on that inflation-related income to investors each year.

Simply because they provide protection against inflation, TIPS belong in your portfolio. But their sterling credit quality and relatively robust returns make them even more attractive.

By Susan Scherreik

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