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TIPS for Inflation: IA Mutual Fund Focus, August 2009

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News and analysis from Standard & Poor’s MarketScope Advisor

Like income taxes, junk mail, health care reform, and Barry Manilow, some things just don’t go away. For investors, inflation is the guest that won’t leave, reappearing unexpectedly from some hidden recess at the most inconvenient moment.

As it turns out, Wall Street has just the thing for those made nervous by the inflationary implications of the government stimulating the economy with $787 billion in new spending while bailing out Fannie Mae, Freddie Mac, AIG, and two of the three U.S. automakers from bankruptcy. Inflation-protected bond funds, also called inflation-indexed funds or “real return” funds, offer investors a defense against accelerating inflation by investing in Treasury Inflation Protected Securities (TIPS), a type of bond issued by the U.S. Treasury since 1997 in which the principal amount changes in line with the Consumer Price Index.

TIPS have attracted increased attention recently, with the Treasury Department announcing in August that investors “can expect issuance to gradually increase” during the 2010 financial year that begins in October. The U.S. Treasury also said it is considering replacing the 20-year TIPS bond with a 30-year bond. (The Treasury stopped issuing 30-year bonds, including 30-year TIPS, in 2001.)

Roughly 25 distinct funds are now being marketed under this category to individual investors, offering a wide variety of investment styles, performance, and costs. The group is generally benchmarked against the Barclays U.S. Government Inflation-Linked Bond Index, which tracks the performance of TIPS with maturities of a year or more. As of early August, the index gained more than 4% year to date. That compares with a decline of 5.15% for Barclay’s U.S. Treasury bond market index.

Two funds dominate the field of inflation-linked funds: Vanguard’s Inflation Protected Securities Fund (VIPSX), with $22.3 billion in assets, and PIMCO’s Real Return Fund (PRTNX), with $13.2 billion. These funds differ greatly in portfolio holdings and expenses, yet over the long term both have produced returns very close to their benchmark.

At the end of June 2009, the Vanguard fund held 100% of its assets in 24 different TIPS issues. Similar funds include the Hartford Inflation Plus Fund (HIPAX), with $1.2 billion in assets and 92% of its assets in TIPS (the remaining 8% in either cash or other U.S. Treasury debt); the smaller Dreyfus Inflation Adjusted Securities Fund (DIAVX), with 98% of its $67 million in assets in TIPS and other Treasury securities; the $352 million MFS Inflation-Adjusted Bond Fund (MIAAX) all invested in TIPS; and the $700 million TIAA CREF Inflation Linked Bond Fund (TCILX), also totally invested in TIPS.

PIMCO’s Real Return Fund and several others take a slightly different approach, holding the bulk of their assets–usually 80% or more–in TIPS but also holding foreign government debt (sometimes inflation indexed as well) or even common stocks of commodity-related companies that tend to do well during periods of accelerating inflation. In addition to TIPS, PIMCO’s fund is invested in several different foreign currencies as well as corporate bonds, both domestic and international. Other funds using a similar strategy include the $322 million Franklin Real Return Fund (FRRAX), which had $66% of its assets invested in TIPS, 16% invested in foreign government bonds that are also indexed to inflation, 6% in common stocks of natural resource companies and most of the rest in junk bonds; and the American Century Inflation Adjusted Bond fund (ACITX), which has 88% of its $1.7 billion in assets invested in inflation indexed bonds with most of the remaining portion in corporate bonds, municipal bonds, and mortgage-backed debt.

Expenses vary considerably for TIPS funds. Vanguard’s fund has an expense ratio of just 0.25%, but others range from about 0.5% to 1.0% or more. Several funds, including PIMCO’s, Hartford’s and MFS’s, charge an initial sales load (3.0% for Pimco, 4.5% for Hartford’s, and 4.75% for MFS).