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| The Basics | Insure your portfolio against inflation
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Inflation-protected bonds are a hedge against inflation and the safest way to diversify a portfolio. Buy them through a mutual fund.
By Timothy Middleton
The inflation sky is not falling.
At least, thats what the market for Treasury Inflation-Protected Securities, or TIPS, is saying. These unusual bonds -- the rare investment guaranteed to keep pace with inflation -- trade on the open market just like other bonds and stocks. When their price goes down, it means investors expect more inflation. When the yield declines, inflation fears are ebbing.
Right now the market is saying the long-term outlook for inflation is tame.
Even so, you probably ought to own TIPS, because they act like a mini insurance policy in your portfolio. In times when other investments sink, these will typically stay afloat.
If the market is wrong and inflation really does accelerate, for example, these bonds will beat inflation, as measured by the Consumer Price Index, no matter how high it goes.
The best way to own TIPS, I believe, is through mutual funds. The reason: If you own the bond itself, you don't get the inflation-matching bump until you cash it in five or 10 years down the line. If you own the fund, its value changes from day to day, meaning any increase in inflation, and thus the bond's real value, is recognized immediately.
Beating inflation, but lagging Treasurys
The United States adopted inflation-linked bonds in 1997. So long as inflation is tame -- keeping TIPS rates low -- they are a bargain for the government.
Related news and commentary on MSN Money
The 10-year TIPS has a real, or coupon, rate of return of 2%. Thats all the Treasury is required to pay out every year. A conventional Treasury bond yields roughly 4.6%, all of it paid at regular intervals.
But in addition to its real return, a TIPS bond captures the so-called headline inflation rate, as opposed to the much lower core rate, which excludes the cost of energy and food because those two categories are so volatile. The headline rate went up 1.22% in September alone with better than 90% of that attributable to higher energy prices. The bond's face value is thus increased by 1.22%, with a lag of two months. Since the bond now trades below its face value, the value of the bond increases by about 1.25%. (The market is aware of the coming increase and has priced it into the bonds.)
Since the bond pays a real return of 2%, that coupon rises as the principal value of the bond rises. Whether you own TIPS through a fund or directly (and you can buy them without any fees through TreasuryDirect), you capture that higher coupon as it accrues. But only a mutual fund captures the increase in the principal value contemporaneously; individual owners have to wait until the bond matures.
You can also capture lower values in a fund, and so far this year conventional bonds are outperforming TIPS slightly. As of last week the Lehman U.S. TIPS Index had gained 1.16% this year, compared with the 1.27% gain of the Lehman U.S. Aggregate Bond Index, which tracks the value of nominal Treasurys and corporate bonds.
Still vulnerable to rising interest rates
Brian Brennan, co-manager of T. Rowe Price Inflation Protected Bond (PRIPX), attributes the underperformance to several factors, including a big increase in supply. The TIPS market is tiny, about 1% of the Treasury marketplace, and recent auctions of five- and 10-year TIPS have been relatively large.
Also weighing on TIPS, Brennan says, is the fact that they have longer average maturities than the bond market itself. The longer the maturity, the more a bonds price reacts to rising interest rates, and the rate on the 10-year nominal Treasury has jumped to 4.6% from 4% only a few months ago.
Despite these factors, TIPS are attractive as a hedge against inflation, and for their diversification benefit. Vanguards Volpert suggests that instead of owning the classic mix of 60% stocks and 40% high-quality bonds (the typical balanced fund), you combine 60% stocks, 5% to 10% TIPS and the balance in Treasurys and other investment-grade bonds.
This mix is less risky, but produces the same expected return, Volpert says.
Gauging the inflation risk
Among funds, the choices are actively managed mutual funds, such as those of Vanguard, Fidelity, Delaware and T. Rowe Price, and the passively managed exchange-traded fund, iShares Lehman TIPS (TIP, news, msgs).
The iShares fund has only been around since the end of 2003, and the Delaware fund since the end of last year. This year, as of Oct. 26, the iShares fund was up 0.93%, trailed by Delaware (0.73%), Vanguard (0.72%) and T. Rowe Price (0.4%).
The oldest and largest TIPS fund, Pimco Real Return (PRRIX), was ahead 0.75%.
Another popular inflation-linked security is the I Bond, similar to Savings Bonds but with CPI protection. There is no secondary market for these bonds, so they are more a form of savings than investment.
You can buy I Bonds anywhere conventional savings bonds are sold; many employers let you buy them with regular automated payroll withdrawals. You can also buy them from TreasuryDirect. I Bonds currently yield 4.80%, substantially more than the 3.50% rate on savings bonds. That rate is reset every six months and the next reset occurs today. Unlike TIPS, I Bonds add the inflation premium to the yield, not the principal value. You can learn about them here.
The markets expectation of an average inflation rate of 2.5% in coming years doesnt preclude the possibility it will be very high some years and very low in others. And the market could be wrong: President Gerald Ford promised to Whip Inflation Now in the mid-1970s, and instead it accelerated madly.
So I think a TIPS fund has a place in most portfolios.
At the time of original publication, Timothy Middleton owned none of the mutual funds mentioned in this article.
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