TIPS gaining new respect from nervous investors


FOR MUCH of their existence, Treasury inflation-protected securities haven't generated much excitement among investors, and there was even talk at one point of killing off the bonds.

When the government introduced TIPS in 1997, the stock market was raging and gains of 20 percent or more were far more alluring than these complicated bonds that promise to keep up with inflation.

Back then, too, the government enjoyed a surplus, so there wasn't an urgency to raise money by issuing the bonds.

And it was only a year ago that investors were far more worried more about deflation - or falling prices - than inflation.

"We had such a scare with deflation, that to try to protect yourself against something that was not really a problem didn't seem like such a good idea," said Paul Corbin, head of fixed income at Brown Advisory in Baltimore.

But that's changed. The deficit is soaring. Deflation fears are dead. Investors, now faced with the prospect of rising interest rates and higher inflation, have new-found respect for TIPS.

Money has been pouring into TIPS and mutual funds that invest in them. For example, for the first three months of this year, about $4.6 billion flowed into TIPS funds, compared with $1.6 billion for the first quarter the year before, according to estimates by Lipper Inc., the mutual fund tracking company.

As demand has risen, so has the number of TIPS funds. Of the 21 TIPS funds today, a third were created since last year, according to Lipper.

The TIPS market is expanding in other ways, too. The Treasury Department announced recently that in addition to the current 10-year TIPS, it will begin offering 5-year and 20-year TIPS this year.

TIPS are complex. They are backed by the U.S. government so there's no credit risk.

Basically, the bond pays a fixed-rate of interest, called the coupon, during its life. This income is paid out twice a year to investors.

The sweetener is that the principal is regularly adjusted for inflation based on the Consumer Price Index. Investors don't pocket the increase in principal until the bond matures.

Still, as the principal grows over time, so will the amount investors collect every six months in interest.

"It comes as close to being the perfect investment as you can get," said Harold Evensky, a financial planner in Coral Gables, Fla. "Bonds are typically a place we invest to preserve capital, and equities are where we invest for real return - return over inflation. A TIP provides both."

Ken Volpert, co-manager of the Vanguard Inflation-Protected Securities Fund, said TIPS are like a new asset class because they tend not to closely track the movement of stocks and investment-grade bonds.

"The primary reason to buy them is because of their diversification," Volpert said.

Some suggest as demand for TIPS has grown, the bonds are getting pricey compared with standard Treasury bonds.

Last week, for example, the real yield on 10-year TIPS was about 2.1 percent, Corbin said. (Real yield is a combination of the coupon rate plus the market price, which can go up or down.)

In comparison, the yield on a regular 10-year Treasury was about 4.8 percent, Corbin said. The difference - 2.7 percent - is the expectation for inflation.

Investors come out ahead with TIPS if annual inflation is higher than 2.7 percent. If it's lower, then the conventional Treasury bond would turn out to be the better investment.

"If rates go up because inflation is going up, TIPS will do great," said John Brynjolfsson, who manages the largest TIPS fund, the PIMCO Real Return Bond Fund, with $11 billion in assets.

But if the Federal Reserve aggressively raises interest rates to head off inflation, then both conventional bond and TIPS "will suffer the wrath of the Fed," Brynjolfsson said.

Other factors, and drawbacks:

Taxes. As with other Treasury bonds, investors don't pay state or local taxes on TIPS income. They will pay federal taxes on the interest income received twice a year.

But TIPS have another twist. Any increases in principal during the year because of inflation will be taxed at that time, even though investors won't receive that money until later.

This is one reason why experts advise holding TIPS in tax-sheltered accounts, such as an individual retirement account or 401(k).

Funds vs. individual TIPS. Investors can buy individual TIPS directly from the Treasury at for a minimum investment of $1,000. The initial investment in a TIPS fund can be as little as $50 provided investors make regular, automatic investments.

One advantage of a TIPS fund is that mutual funds are required to distribute all taxable income each year, experts said. That means mutual fund investors will receive interest income plus any adjustments in principal each year.

Like with all bond funds, investors potentially can lose their principal in a TIPS fund, depending on market conditions when they sell their shares. Likewise, if they sell an individual bond before it matures, the amount they get will be determined by the market.

Inflation rate. Federal Reserve Chairman Alan Green- span is among those who say the Consumer Price Index overstates inflation. He has suggested changes.

If the CPI were revised to reflect a lower rate of inflation, that could be devastating to TIPS, said Susan B. Fulton, a portfolio manager in Bethesda.

"The bond's value will be dropped dramatically," she said. "Secondly, the investor isn't getting what they thought they were getting."

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at

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