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Looking For Hot Bond TIPS?

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April 29, 2004 — Inflation seems to be gathering steam. So what better time could there be for buying bonds that provide a hedge against rising prices?

Actually, these investments, called Treasury Inflation-Protected Securities, or TIPS, might have made more sense a year ago, when their prices were lower, some money managers say. But they’re still attractive now, they maintain.

Unlike conventional U.S. Treasury bonds, the principal on TIPS is periodically adjusted for changes in the inflation rate, so what investors receive in interest changes, but the face value of the bond at maturity does not. TIPS can be purchased individually from the Treasury. Investors can also own them through mutual funds.

TIPS funds have proven popular with investors since the securities were introduced seven years ago. The number of funds increased to 17 from four between 1997 and 2003, according to Financial Research Corp. Most recently, the Inflation Protection Securities Fund was introduced by American Express’s AXP fund family in March.

The funds have taken in money each year they have been around, although inflows have risen and fallen. Investments peaked at about $4 billion in 2002 before easing to $3.75 billion last year, FRC data shows. This year, the funds had netted $1.5 billion through February.

But as TIPS have become more popular, their prices have risen to the point where some portfolio managers think regular Treasuries are an equally good investment, although not necessarily a better one.

The difference in yield between a 10-year TIPS note and a regular 10-year Treasury note is about 2.5 percentage points. That implies that inflation will average 2.5% for the next decade. But inflation has been increasing at a 1.7% annual rate of late, so investors are paying a premium for inflation insurance.

Casey Colton, lead manager of the $600 million American Century Cap Value/Inv (ACTIX), thinks yield spreads a year ago made Treasuries less appealing than they are currently.

“Now that we’re starting to see some of the signs that inflation is picking up, in my opinion, short-term, a lot of the value of TIPS is reflected in their price currently,” says Daniel Shackelford, who manages the $45 million T Rowe Price Inflation Protection (PRIPX).

Over the long term, however, Shackelford thinks investors should allocate part of their assets to TIPS funds because they provide inflation protection, among other things.

Other fund managers had a more optimistic outlook for TIPS in the near term.

Kenneth Volpert, who helps run the $6.4 billion Vanguard Inflation Protected Securities (VIPSX), argues that if inflation is gathering momentum, this is the “best time” to buy TIPS funds because of their inflation hedging properties. If inflation increases at a 2.5% rate for ten years, then TIPS prices do not seem “unreasonable,” he says.

William Davison, co-manager of the $570 million Hartford Inflation Plus Fund/A (HIPAX), offers similar opinions. TIPS prices are “fairly low by historical standards,” he says.

Money managers point out that the benefits of TIPS go beyond inflation protection. For one, they’re less volatile than conventional Treasuries.

Also, the performance of TIPS tends not to follow other asset classes, so the securities can help diversify portfolios. TIPS “are negatively correlated to equities, and they have a very low correlation to high-yield” bonds, Davison notes.

Their use in diversifying portfolios makes TIPS “a holding that’s always made sense,” says Jamie Jackson, who oversees the new AXP Inflation Protection Securities Fund, which has about $25 million in assets.

Inflation-protected securities are not without risks, though. If inflation is low, investors could do better in regular Treasuries.

The popularity of TIPS could also lead to a supply-demand imbalance, says Kristin Adamonis, an FRC writer who has written about the securities. There are currently fewer outstanding TIPS issues (12) than there are funds that invest in them, she noted in a recent article. If demand for TIPS greatly exceeds supplies, then fund managers could be forced to buy TIPS at a large premium, she says.

But fund managers say they do not see supplies as a problem, because the Treasury has said it will support the market. The Treasury has also proposed bringing out TIPS with a maturity of 20 or 30 years, they say.

Vanguard Group said last month that the outstanding value of all existing TIPS was a little more than $200 billion, which represented less than 1% of the $24 trillion value of the U.S. security markets, including fixed-income securities and stocks.

A jump in wholesale prices last month could lead investors to seek inflation-protected securities. The Labor Department reported last week that the Producer Price Index surged 0.5% in March. Excluding volatile food and energy costs, the so-called core index advanced 0.2%. But both figures exceeded estimates of Wall Street economists.

Listed below are the five largest TIPS funds and their average annualized returns for the three years ended in March. One of the offerings, Fidelity Inflation Protected Securities, is too new to be ranked by Standard & Poor’s since it has less than three years of operating history.

TIPS Fund Assets* Three-Year Returns Through 3/31/04** S&P Star Rank
PIMCO Funds:Real Return Bond Fund/Instl (PRRIX) $2.8 billion +11.3% 5
Vanguard Inflation Protected Securities (VIPSX) $5.2 billion +10.8% 4
Fidelity Inflation-Protected Bond (FINPX) $787 million *** Not ranked.
GMO Tr Inflation Index Bond Fund/III (GMIIX) $403 million +10.2% 4
BBH Inflation Indexed Securities Fund/N (BBHIX) $387 million +11.2% 5

*As of 1/31/04. Source: Financial Research Corp.

**Source: Standard & Poor’s. Total returns include reinvested dividends.