4 low-risk investments that maintain the gain
| | Mutual Funds
Every portfolio needs inflation insurance
Even with inflation at low levels, inflation-indexed bonds are hot. But they're not as simple as they look. Here's a complete guide.
By Timothy Middleton
With the global economy in the throes of recession and the worst bear market in modern times, why would anybody be worried about inflation?
The best time to buy flood insurance is during a drought, says John Hollyer, co-manager of Vanguard Inflation-Protected Securities Fund (VIPSX). If very little premium is being charged for insurance against higher inflation, thats a good time to buy the insurance.
Inflation-indexed bonds are better known as TIPS, for Treasury Inflation Protected Securities. Probably the real reason theyve become so popular is that investors are simply terrified of everything else. So as they have flooded into the tiny TIPS marketplace -- it accounts for only 2% of actively traded Treasury bonds -- they have sent prices skyrocketing.
Hollyers fund advanced more than 12% in the first 10 months of this year, outperforming an already ebullient government bond market by 30%. His assets have surged to $2.8 billion, from $750 million at the beginning of the year.
Pimco Real Return Bond Fund (PRTNX) has delivered similar results, and its assets have ballooned to $6 billion from $2.9 billion. Pimco is the largest player in inflation-protected bonds, and has excelled since they were introduced by the Treasury in January 1997.
Beating your boss
Pimco manager John Brynjolfsson has even bettered the returns of his boss, bond legend Bill Gross; Brynjolfssons five-year returns as of Oct. 31 were 8.6%, compared with 7.5% at Grosss Pimco Total Return (PTTAX).
TIPS are attractive relative to Treasurys, and the key is that Treasurys and TIPS represent quality, Brynjolfsson says. Rival bonds reflect rolling the dice on the future prospects of the corporate sector.
TIPS can play a role in almost any portfolio, but the investors racing into them now are lemmings. Interest rates are at 40-year lows, held down by the Federal Reserve in the hope they will stimulate economic growth, which eventually translates into higher interest rates.
If we have a spate of rising rates in the next year and a half, not matched by robust inflation, TIPS are going to sell off pretty hard, says Morningstar analyst Eric Jacobson. If you dont own them now, I would dollar-cost average into them.
For long-term investors, TIPS take the guesswork out of buying Treasurys. Conventional T-bonds are vulnerable to rising inflation. TIPS aren't.
A guarantee
They guarantee a real rate of return, says Lal Chugh, professor of finance at the University of Massachusetts, Boston. Coupons increase with the rate of inflation. With (other) Treasurys, the coupon payments do not go up.
And coupons arent the only part of TIPS that become more valuable when inflation rises. The value of the bonds principal increases in direct proportion to the consumer price index. To take an example that ignores compounding for the sake of clarity, some $10,000 worth of TIPS today would be worth $12,000 in 10 years if inflation rose 2% a year.
And that's in addition to the bonds interest payments. They rise, too. The coupon on the July 2012 TIPS is 3%, or $300 annually on a $10,000 stake. Ten years from now, if the principal value has risen to $12,000, the investment will still be yielding 3%, but that will be $360.
The Treasury makes buying TIPS very easy. They sell in five- and 10-year maturities in auctions held three times a year. They sell in multiples of $1,000 and can be bought over the Internet or from banks and savings and loans.
And they're easy to understand. Twice a year, you get a check from Uncle Sam, just as you would on any other Treasury. It will be less than the standard Treasury yield -- about 1.5% less currently, since the traditional bond has an inflation-risk premium built into its price -- but youll also be getting that phantom income: the rising principal value of the bond.
There's a bit more to it
Actually, its not quite that simple, which is why owning TIPS in the form of a mutual fund can be a very good idea.
Even though you dont get it, that phantom income is taxable. Chugh, the University of Massachusetts professor who has researched TIPS, says this hidden tax cost makes TIPS unsuitable for a taxable brokerage account. In a 401(k) plan, then they are a great opportunity, he says.
But for fund investors, this implied increase in the principal value of the bonds isn't a phantasm. It's actually paid to shareholders every year. Funds calculate the phantom income each year and distribute it as cash, along with interest income.
So while owners of the individual securities are paying taxes today on income theyll potentially get 10 years from now, fund shareholders pay the same taxes but dont have to wait for their money.
Also, bond investors get checks they cannot reinvest in more bonds, unless the check is for increments of $1,000. Fund investors get dividends they can, and usually do, reinvest. So its easier for fund shareholders to benefit from the power of compounding.
(There is a savings-bond version of TIPS called I Bonds, available in denominations of $50, but they dont pay current interest; it's deferred until the bond is redeemed.)
Benefiting from the pros
Fund investors benefit from professional management, as well, assuming they dont pay high fees that take this added value away. Over time, says Pimcos Brynjolfsson, the funds active management has added an extra 160 basis points (or 1.6%) to its return compared with its expected performance.
Fund managers can juice returns by employing strategies, such as statistical arbitrage and buying bonds for forward settlement, that are either impossible or impractical for individual investors to exploit.
Pimcos added value is substantially greater than the funds expense ratio of 90 basis points on its A shares. Vanguards expenses are a tiny 25 basis points, or hundredths of a percentage point.
And then theres the matter of liquidity. Its easy to buy an individual TIPS, but hard to sell one. The Treasury wont buy it back; youve got to sell through a broker or bank, and the commission will be a significant part of the bonds annual interest, because there's little retail-investor demand for used bonds.
So even if inflation were to take off, owners of bonds would have to wait until they mature to realize the gains. But fund net asset values would rise, and their shareholders could cash out whenever they wanted.
No sure thing
Despite being backed by the federal government, TIPS aren't a sure thing.
When people hear inflation, they think of a floating-rate, limited-price-sensitivity product, and thats not what this is, says Tom Silvia, manager of Fidelity Inflation-protected Bond Fund (FINPX), which was launched in June.
Rather, just like conventional Treasury bonds, TIPS are sensitive to interest rates. How sensitive is itself controversial; even professionals are divided.
Rate sensitivity in bonds is expressed as duration. For most bonds, duration and maturity are similar, but for TIPS they aren't. Pimcos Brynjolfsson calculates that they are about 60% as sensitive as conventional Treasurys.
Specifically, the average maturity of his portfolio is 13.8 years, but the duration is six years. Fidelitys Silvia agrees; the duration of his portfolio is 5.3 years.
Vanguard, on the other hand, thinks theyre only about half as sensitive as that. The funds average maturity is 14.2 years, but its duration is only 2.9 years. The difference: Hollyer thinks higher rates would be due mostly to higher inflation; Brynjolfsson and Silvia can envision a significant rise in rates due mostly to the business cycle, with little upward pressure on inflation.
Safer than Treasurys
If Vanguard is right, a 2% increase in interest rates would lower the value of its bonds by 5.8%. If Pimco is right, that same increase would slash the value of its bonds by 12%. Either way, TIPS are safer than conventional Treasurys, which would tumble 20.4%.
But theyre also far riskier than they might appear. The last time the Fed stopped lowering rates, in September 1992, they rose 2.5 percentage points within 26 months, and three points within 29 months. Those increases produced the worst year, 1994, for bond funds since Morningstar started collecting data in 1977.
Nevertheless, inflation is so quiescent that todays prices provide what Silvia calls a good entry point for those who suspect it could be higher 10 years or more from now. If I owned no TIPS but wanted them eventually to become 20% of my fixed-income portfolio, Id buy them over the next 10 quarters, moving 2% of the portfolio each time.
But I wouldnt be selling my corporate bonds, or stocks, to make the purchases. Id be selling other government bonds, or using fresh money. Treasurys are expensive these days.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
|
