As signs of inflation creep back into the economy, some investors may seek to protect their portfolios from higher consumer prices.

Traditionally, investors have flocked to defensive equity sectors — such as consumer staples, utilities, materials, energy and health care — to escape the threat of inflation. Sam Stovall, chief investment strategist at Standard & Poor’s, notes that these industries tend to outperform the market during periods of rising inflation.

In addition to a range of mutual funds that invest in these sectors, there are a number of exchange-traded funds (ETFs), including S&P Select Consumer Staples SPDR Fund (XLP), S&P Select Utilities SPDR Fund (XLU), S&P Select Materials SPDR Fund (XLB), S&P Select Energy SPDR Fund (XLE), S&P Select Health Care SPDR Fund (XLV), that investors can also employ to make tactical asset allocation decisions. All are traded on the American Stock Exchange, and each represents a particular segment of the S&P 500.

However, another strategy might be to invest in fixed-income securities, particularly Treasury Inflation-Protected Securities, or TIPS, which are bonds issued by the U.S. Treasury Department designed to ward off the deleterious effects of inflation, which hits fixed-income investors particularly hard. Launched in 1997, the U.S. TIPS market currently totals about $275 billion, representing a tiny portion of the fixed-income universe, but about 5% of the U.S. Treasuries market outstanding.

Presently, there are fewer than two dozen mutual funds exclusively focused on inflation-protection using TIPS. There is also one exchange-traded fund dedicated to investing in TIPS — the $2.3-billion iShares Lehman Brothers TIPS Bond Fund (TIP). Introduced in December 2003, this ETF seeks to match results the price and yield performance, before fees and expenses, of the Lehman Brothers U.S. Treasury Inflation Notes Index.

What Are TIPS?

When an investor owns a TIPS security, the principal amount is periodically adjusted to keep pace with inflation, as measured by the Consumer Price Index (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.

John Hyll, co-manager of the $10.4-million Loomis Sayles Inflation-Protection Securities Fund (LSGSX) notes that the attractiveness of TIPS as investments depends on the market’s expectations for inflation, and whether or not such forecasts materialize. The key ingredient in determining the appeal of TIPS lie in their relative price to regular (or nominal) U.S. Treasuries — specifically, the difference between the yield on TIPS and the yield of a regular Treasury of similar maturity. To illustrate, the yield on the 10-Year TIPS currently amounts to 1.6%, while the yield on 10-Year Treasury is about 4.3%. This means that the annual rate of inflation over the next decade has to exceed 2.7% for the TIPS security to outperform the comparable Treasury Note.

TIPS can also make a good component to a diversified portfolio, given that they have poor 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 Treasuries 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 is 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.

Inflation: Benign, or Cause for Worry?

Although inflationary pressures are clearly moving upward — exemplified by a higher-than-expected March CPI report, high oil prices, soaring housing costs, declining consumer confidence, upward pressure on bond yields due to current account and budget deficits, and the escalating costs of wars in Iraq and Afghanistan — inflation in the U.S. has been tame for the past five years, generally just below 3% annually. By contrast, throughout the 1970′s, inflation averaged about 7.4% throughout the decade, creating havoc in the securities markets.

Stovall’s research reveals that a little dose of inflation can actually be beneficial to the equity markets. Since 1970, the S&P 500 Index posted its strongest returns when the annual rate of inflation ranged between 2.0% and 3.9%. The Index fell sharply when the CPI exceeded 4.0%. “We believe, therefore, that the market may welcome a touch of inflation — but not too much — since slightly rising inflation implies that the economy is growing and producers are able to boost earnings through price increases,” he said.

Stovall is somewhat unconcerned about inflation going forward. “Since the Fed’s focus is still on reining in inflation, even before it emerges, our belief is that a repeat of the 1970′s runaway inflation is not likely,” he noted. He added that David Wyss, Standard & Poor’s chief economist, is forecasting CPI and core CPI growth at below 2.5% through 2007.

“The real concern is whether inflation or price levels in general are accelerating beyond the threshold that the Fed deems intolerable,” said Dan Shackelford, manager of the $97.3-million T. Rowe Price Inflation-Protection Bond Fund (PRIPX). “We are flirting with a 3% annual inflation rate, but the core inflation levels remain contained. The Fed will keep a lid on prices.”

However, William Davison, lead manager of the $876-million Hartford Inflation Plus Fund (HIPAX), remains wary about inflation. Based on the recent Producer Price Index data and persistently high crude oil prices, he expects inflation to range between 3.0% and 3.5% the next couple of years. Consequently, Davison is taking a defensive stance in his portfolio by currently allocating 95% of assets in TIPS securities (well above the 80% mandate), and by buying TIPS with short durations, and avoiding interest rate sensitivities. If interest rates move aggressively higher, he may make an increased allocation to Floating-Rate Notes, another defensive and income-producing security. Davidson expects the Fed Funds rate to reach 3.75% by the end of 2005.

While TIPS occupy a small slice of the overall fixed-income pie, they have risen in prominence in the eyes of some observers, who are worried about the spectre of inflation. A few weeks ago, Thomas McManus, investment strategist at Banc of America Securities, raised his recommended stock allocation to 60% from 55%, while increasing his weighting in TIPS to 15% from 10%. However, T. Rowe portfolio manager Shackelford suggests keeping between 5% and 10% of a portfolio’s assets in TIPS.

Davison said the U.S. Government is “extremely supportive” of the TIPS market, and has committed to keep supply robust through a continuing series of bond auctions. TIPS serves at least one valuable service for the Federal government. “It gives them a market-based expectation for inflation, that is, they get a good idea of where the market thinks inflation will be for at least the next ten years,” he said.

One thing seems certain: Funds that invest in TIPS stand to attract more business the more investors fret over inflation. Below is a list of the five largest TIPS funds, their one- and three-year annualized returns, and their respective Standard & Poor’s Stars rank.

FIVE LARGEST OPEN-ENDED TIPS MUTUAL FUNDS (By Asset Size)

FUND NAME

ASSETS* (as of 2/28/05)

One-Year Return Through 3/31/05 (%)

Three-Year Annualized Return Through 3/31/05 (%)

Overall S&P Star Rank

PIMCO Real Return Bond Fund (PRTNX)

$13.63 billion

+3.13

+10.46

4

Vanguard Inflation-Protected Securities (VIPSX)

$8.40 billion

+2.77

+10.25

5

Fidelity Inflation-Protected Bond (FINPX)

$1.44 billion

+2.68

N/A

Not Ranked

American Century Inflation-Adjusted Bond (ACITX)

$957 million

+2.57

+9.52

4

Hartford Inflation Plus Fund (HIPAX)

$851 million

+1.55

N/A

Not Ranked

*Financial Research Corp.

Source: Standard & Poor’s. Data as of 03/31/05.

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