June 20, 2006

Some TIPS for Fighting Inflation

A novel approach from the fixed-income universe

In response to signs of rising inflation in the U.S. economy, the Federal Reserve is widely expected to increase short-term interest rates in late June, leaving investors wondering how to battle higher consumer prices.

The Consumer Price Index (CPI) gained 0.4% in May, while the core rate of inflation (excluding food and energy) rose 0.3% -- both figures came in above Standard & Poor's expectations. "The stronger-than-expected pricing data will likely add to inflation fears, adding upward pressure to yields and holding down equity prices," said David Wyss, Standard & Poor's chief economist. "Year-over-year, the headline index accelerated to a 4.2% pace from 3.5% in April. Moreover, the core index accelerated to a 2.4% pace from 2.3% the month before."

The annual inflation rate has been relatively low since the mid-1980s and never exceeded 5.4%. Dropping to a low of 1.6% in 1998, the inflation rate has been steadily ascending, reaching 3.4% in 2005.

Wyss said he expects the Fed to hike rates to 5.25% in June, and perhaps again in August to 5.50% -- but he thinks these moves will have to be reversed next year. "The incoming data suggest that the economy is slowing more suddenly than we expected, but also that inflation is heating up," he said. "The Fed is torn between these trends. We think the logical thing for the Fed to do is take June off and start looking at the data meeting by meeting."

Wyss also noted that since inflation is a lagging indicator, the "actions the Fed has already taken will bring inflation down next year. Inflation will probably peak at the end of this year, with the core figure at about 2.5%."

So, what are investors to do?

Investors have traditionally sought defensive equity sectors -- such as consumer staples, utilities, materials, energy and health care -- to fight inflation. Sam Stovall, chief investment strategist at Standard & Poor's, notes that these industries tend to outperform the market during periods of rising inflation.

A more novel strategy to battle inflation may come from the fixed-income universe, particularly Treasury Inflation-Protected Securities, or TIPS, which are bonds issued by the U.S. Treasury Department. Launched in 1997, the U.S. TIPS market currently totals about $370 billion, representing a small portion of the total fixed-income universe, and approximately 9.5% of the total marketable nominal U.S. Treasuries outstanding.

Presently, there are a handful of mutual funds that primarily invest in inflation-linked bonds, as well as one exchange-traded fund dedicated to investing in TIPS -- the $3.8-billion iShares Lehman TIPS Bond Fund (TIP). Introduced in December 2003, this ETF seeks to match the price and yield performance, before fees and expenses, of the Lehman Brothers U.S. Treasury Inflation Notes Index.

When an investor owns a TIPS security, the principal amount is periodically adjusted to keep pace with inflation, as measured by the CPI. TIPS provide investors with a haven from inflation, as well as a "real return" over inflation throughout the investment period. For example, if the CPI goes up by 0.7%, the value of the TIPS bond would also climb by 0.7%. If the CPI were to fall, the bond's value would not decline too much since the government guarantees the original investment will remain the same.

At maturity, the TIPS bond is redeemed at either its inflation-adjusted principal amount or its original par value, whichever has greater value. However, since inflation is likely to take place over the life of the security, the payment to the holder will probably be greater than the bond's original par value. The rate of interest on the TIPS is applied to the inflation-adjusted principal, not to the par amount. Moreover, since TIPS are primarily issued by the Treasury Department, their repayment is guaranteed by the federal government and they feature negligible credit and default risks.

To illustrate how TIPS perform, John Hyll, manager of the Loomis Sayles Inflation-Protected Securities Fund (LSGSX), said that the yield on the current 10-year TIPS is about 2.5%, while the yield on the regular 10-year Treasury is about 5.1%. This means that over the next ten years the annual rate of inflation has to exceed 2.6% for the TIPS security to outperform the comparable Treasury bond. "In the short term, however, the performance of TIPS is more a function of the market's expectation of future inflation rates rather than the actual inflation numbers," he said.

TIPS can also make a good component to a diversified portfolio, given that they have low correlation with the performance of other bonds as well as stocks. However, while TIPS may appear to be a foolproof investment, they carry some risks. For one thing, to receive the full guaranteed real return, a TIPS security must be held through maturity, otherwise short-term swings in the real yield could hurt TIPS' overall performance. In addition, the interest rate paid by TIPS is lower than that of similar Treasury securities.

Like other Treasuries, TIPS' interest earnings are exempt from state and local income taxes. However, TIPS owners are subject to federal income tax on interest payments in the year they are received, and on the growth in principal in the year that it occurs. If inflation were low, TIPS would likely underperform regular Treasuries; in the unlikely event of deflation, the value of TIPS would plunge, though holders would be guaranteed to receive no less than the security's original par value.

Palash R. Ghosh

FIVE LARGEST OPEN-ENDED TIPS MUTUAL FUNDS/ETFs

FUND NAME

ASSETS*

One-Year Return Through 5/31/06 (%)

Three-Year Annualized Return Through 5/31/06 (%)

Overall S&P Star Rank

PIMCO Funds:Real Return Bond/A (PRTNX)

$14.0 billion

-1.75

+3.32

5

Vanguard Inflation Protected Securities (VIPSX)

$9.4 billion

-1.61

+3.16

5

iShares Lehman TIPS Bond Fund (TIP)

$3.8 billion

-1.58

N.A.

N.A.

PIMCO Funds:Real Return Asset/Ist (PRAIX)

$2.5 billion

-5.17

+4.64

5

Fidelity Inflation-Protected Bond (FINPX)

$1.4 billion

-1.83

+2.93

4

Source: Stand Poor's. Data as of 05/31/06.

*Asset data refers to all share classes combined. Returns data and Star ranking refer to the listed share class.



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