Why TIPS Are Still A Buy

Despite a recent slide, they provide a sound inflation hedge

Economists are uniform in praising Treasury Inflation-Protected Securities (TIPS), as one of the best safeguards against an overall rise in prices. Yet toward the end of August, with the annualized rise in the consumer price index (CPI) running around 3%, oil flirting with $50 a barrel, and Wall Street sounding repeated warnings about inflation pressures, the value of TIPS declined. Some inflation hedge, right?

Don't be misled by short-term fluctuations in the market. TIPS will, indeed, behave as they were intended to -- if you hold them until maturity. You're assured of a real, after-inflation return because the bond's principal is adjusted to reflect changes in the CPI. The inflation adjustment occurs semi-annually but uses the data available closest to the adjustment date. The current real fixed-interest rates are just 1.8% on a 10-year and 2.2% on a 30-year issue.

In the meantime, TIPS prices often bounce around as inflation expectations rise and fall -- and right now they're waning. Demand from professional bond traders is down, too. Real yields would have to go much higher -- say, near 3% -- to attract their interest, says Bulent Baygun, head of fixed-income strategy at Barclays Capital. Even so, TIPS are having a good year, sporting a total return of 5.2% compared with 3.1% for the Lehman Brothers (LEH ) Aggregate Bond index and 2.1% for the Standard & Poor's 500-stock index.

NOT SO VOLATILE

If you can get past the short-term price wariness, TIPS are a compelling investment. For one thing, inflation-indexed bonds are increasingly perceived as a separate asset class because they don't follow the movement of other types of investments such as stocks and conventional bonds, says David Darst, chief investment strategist for Morgan Stanley's Individual Investor Group. In other words, TIPS add diversification to your portfolio. Over the past five years, they've had a negative correlation with the S&P 500 and the Lehman U.S. Aggregate Bond index. They're also about a third less volatile than traditional Treasury bonds of similar maturity. "TIPS certainly belong in most folks' retirement portfolios," says William Bernstein, author of the Intelligent Asset Allocator. "The return is not bad, and they provide a decent inflation hedge."

The inflation-linked market is also becoming increasingly liquid. The U.S. government started selling TIPS in 1997, and the market now exceeds $220 billion, according to Bridgewater Associates, an investment research firm. TIPS of various maturities are expected to make up about 16% of the Treasury market (excluding Treasury bills) by 2009, says Barclays' Baygun.

There are new entries to the inflation-indexed market: some $9 billion in corporate inflation-linked bonds. Most issuers are blue-chip borrowers such as Fannie Mae (FNM ), Sallie Mae (SLM ), and Morgan Stanley (MWD ). The corporate bonds are more sensitive than TIPS to short-term swings in the inflation rate since they pay interest monthly, based on the CPI for the trailing 12 months. Still, they aren't generating much enthusiasm from investors, mainly because they're paying on average a mere 0.5 of a percentage point more than comparable TIPS. "There haven't been many issuers, and the small amount of extra yield hasn't typically made up for the credit risk and the state income tax exemption on TIPS," says Ross Levin, president of Accredited Investors, a financial-planning firm in Minneapolis.

In the end, inflation-indexed securities backed by the U.S. government still rank among the safest long-term investments. So don't be fooled -- or worried -- by price fluctuations. If there is even a remote chance that inflation will stir, you should consider TIPS as a core holding.

By Christopher Farrell

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