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TIPS help you whip inflation now
Treasury inflation-protected securities won't build wealth for you -- that's the job of stocks. But they offer valuable support for your portfolio with inflation on the rise.
By Timothy Middleton
Inflation, long dormant, is back. The consumer price index spurted 3.1% in the 12 months ended March 31. Worse, it is accelerating: If the first-quarter rate continues all year, prices will finish 2005 up 4.3%. In 2003, prices rose just 1.9%.
Inflation is bad for bonds, since it erodes their purchasing power. There is an exception, however: Treasury inflation-protected securities, or TIPS. Specifically designed to preserve buying power even when inflation rages, they are doing their job.
Here's evidence: The Vanguard Inflation-Protected Securities (VIPSX) fund, which invests in TIPS, is up 1.3% this year, as of May 3, nearly three times the 0.46% return of iShares Lehman Aggregate Bond Fund (AGG, news, msgs), an exchange-traded fund that tracks the overall bond market.
TIPS and the mutual funds that invest in them aren't for everyone. Corporate and mortgage bonds pay higher average yields, for example.
And while TIPS offer inflation protection, they are limited in their ability to build wealth. Yes, you'll beat inflation, but only by a little. Rely too heavily on these, and your retirement nest egg will grow only slightly faster than its purchasing power is eroded by inflation. For most long-term investors, bonds and TIPS should play a supporting role in an equity-heavy portfolio.
But for the lower-risk portion of your portfolio that you do dedicate to bonds, TIPS are a good bet, particularly if, like Fed Chairman Alan Greenspan, you fear inflation could accelerate.
They have far outperformed other Treasury bonds in recent years and will likely continue to do so. The Treasury placed a wager that inflation was dead when it introduced the bonds in 1997, but it's losing the bet. The winners are investors.
Fending off inflation's ravages
Inflation is to interest rates as a cake is to icing: Most, but not all, of what's there. The Federal Reserve can set very short-term rates, boosting or shaving them to manipulate the economy, but bond investors set long-term rates with their wallets. Offer less than what they expect to equal future inflation, plus taxes on earnings, and they won't buy your bonds.
But part of the Fed's short-term rate manipulation is designed to control inflation, which is the core job of any central bank. It has explicitly said as much in recent months as it boosted short rates to 3% today, from 1% a year ago, with the latest hike coming last week. As I reported two weeks ago, today you can earn more than 3% on a six-month Treasury bill (which is, essentially, cash), while the 10-year Treasury is yielding little more, 4.2%.
A 10-year TIP yields 1.6% percentage points above the inflation rate; that is, a real return. The largest TIPS fund stresses this attribute of the bonds in its name -- Pimco Real Return D (PRRDX).
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The inflation rate, expressed as the CPI, is built into the principal value of a TIPS bond. Every year, the Treasury resets the value of the bonds to reflect the increase in consumer prices. Bond-market participants revalue them moment to moment, and currently assume an inflation rate of 2.6%, making the total return of the 10-year TIPS 4.2%, the same as an ordinary 10-year Treasury bond.
In reality, however, inflation is rising faster than that (as witnessed by the first-quarter CPI, which rose at a 4.3% annual rate). The value of TIPS securities -- which is set by the Treasury -- has been driven up beyond Treasury returns for years because actual inflation has outstripped what the market expected. The Vanguard Inflation-Protected fund returned 16.6% in 2002, some 6 percentage points more than bonds in general. The fund beat bond-market indexes by nearly 4 points in 2003 and the same in 2004.
In addition to inflation expectations, that outperformance was partly due to TIPS' relatively long maturities. You have to wait an average of nine years to get your money back. So just as with other bonds, falling rates make them more valuable, because investors perceive they'll get smaller returns from new bonds issued at lower rates.
By the same token, rising interest rates hurt TIPS to the degree they're not caused by inflation -- that they are part of the icing (Fed action), not the cake (inflation). The thickness of that icing is not fixed. Today investors demand a real return of 1.6% on the 10-year TIPS. If tomorrow investors demand 2%, because they assume interest rates will rise, the price of the TIPS will fall.
On top of their complexity, TIPS also are misunderstood because there are so few of them -- only 16 separate bonds with a total value of $300 billion, just 12.5% of the $2.4 trillion Treasury market and only about 1.2% of the $25 trillion domestic bond market. Only a dozen or so bond firms specialize in the market.
There are two main reasons interest in the bonds is so slight.
- Those longer maturities. Intermediate-term bonds, whose prices are less interest-rate sensitive, have average maturities of around six years.
- TIPs are hard to value. The TIPS market is vulnerable to all manner of technical ripples that make them difficult to analyze. The inflation component of the bond's return is linked to a consumer price index series that is not seasonally adjusted. That means the index is vulnerable to bigger monthly ups and downs.
In the spring, the unadjusted index tends to overstate inflation, as people travel more and fire up their air conditioners, which buoys the bonds. In the summer, it tends to understate price increases, working against the bonds.
These seasonal factors don't have a huge impact on TIPS, but they unsettle them more than conventional Treasurys. That means market-timers might like them today, dump them in six weeks and buy them back two months after that.
Also, the market is so small that new supply can overwhelm existing demand, depressing prices. The Treasury plans to sell nearly $20 billion in TIPS in July in two categories, one with a maturity of 10 years and the other 20. That's equal to nearly 6.7% of the total TIPS market.
A tip: Think long term
Despite this short-term risk, I'm not afraid of the TIPS market, and you shouldn't be, either. "If you buy them with a long-term perspective, then it's impossible to be surprised," says John Brynjolfsson, manager of the Pimco fund. "The bonds have a contractually guaranteed real return."
Moreover, the odds favor more inflation over less. The Federal Reserve fretted about deflation while it held short-term rates at 1% for so long. Clearly, it now thinks inflation is more likely. With that scent in the air, the price of the ultimate inflation hedge, gold, has soared to $430 an ounce from $270 only a few years ago.
In my personal portfolio, I have half my bond investments in a TIPS fund, T. Rowe Price Inflation Protected Bond (PRIPX), and the other half in an intermediate-term fund that owns the broad market, including corporate bonds that accept credit risk and therefore usually outperform Treasurys.
I can't be sure TIPS will always outperform other bonds, but I know they will if inflation accelerates, because, as I noted, inflation is poison to those other bonds. The blend of the two strikes me as a way to greatly reduce the volatility of my overall portfolio without sacrificing a real return on at least part of it if inflation turns ugly.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: T. Rowe Price Inflation Protected Bond Fund.
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