ALBERT HERTER

‘TIPS BUY PEACE OF MIND, BUT AT A STEEP PRICE,’ by Brett Arends in the Wall St. Journal at fidelity.com.

In Uncategorized on October 30, 2009 at 11:25

TIPS buy peace of mind, but at a steep price

BY BRETT ARENDS,  THE WALL STREET JOURNAL — 10/27/09

Current yields, high prices make short-term bonds less appealing; best bets at 20 years or more.

Inflation-protected US government bonds are generally a great core holding for ordinary investors. That’s especially true in uncertain times like these, when many worry that a spike in prices is just around the corner.

 

But here’s the secret of TIPS: You don’t buy them because you know where inflation is headed. You buy them so you don’t have to care.

 

Shares may boom or slump, inflation may rise or fall, but if you buy a long-term inflation-protected bond that pays 3% a year above inflation, that’s what you get.

 

TIPS have performed well this year — the sector is up around 9% since Jan. 1. But their good performance means that many of these bonds are now distressingly expensive. That’s especially true for the shorter-term bonds, which mature within the next five years or so. Today’s bond buyers may not realize it, but they are locking in poor investment returns. With prices at current levels, longer-term bonds, particularly those maturing in 20 years or more, look like better values.

 

Treasury Inflation-Protected Securities, or TIPS, have been around since the late 1990s. Unlike regular bonds, their price and coupons are adjusted to reflect inflation, which makes them a good safe haven investment. The bonds are safe from default because they are guaranteed by the U.S. government, and they are safe against inflation as well.

 

And inflation is a topic very much on investors’ minds right now. Some fear that the vast amounts of federal stimulus money poured into the economy will eventually lead to devaluation of the dollar and skyrocketing prices. Indeed you can see some of that already in the slump in the value of the dollar and the rise of gold. (However, falling yields on regular bonds, including non-protected Treasurys, suggest we might instead see deflation first.)

 

Inflation fears are one reason many ordinary investors have been loading up on TIPS, pushing up the price of those bonds. According to Financial Research Corp., a Boston-based firm that tracks mutual funds, investors have poured about $20 billion into inflation-protected bond funds so far this year — about the same amount they’ve invested in diversified emerging markets funds.

 

Buying TIPS buys peace of mind, but the price you pay for that peace matters greatly.

 

TIPS are generally quoted in terms of their “real” yield, which means the annual return above inflation. So if a bond has a “real yield” of 3% a year, if inflation comes in at 0% you’ll earn 3%. If inflation comes in at 10% you’ll earn 13%, and so on.

 

As a rough rule of thumb, TIPS deliver good value only when the real yield is over 2%, and preferably higher than that. (Last fall, during the depths of the financial crisis, some real yields shot up to 4% or higher as stricken financial institutions sold everything they could in a desperate bid to raise cash. It was free money, with effectively no risk at all.)

 

Even though TIPS have only been around for a little more than a decade, this rule has a long-term historic basis. Over the past half-century, investors in the benchmark ten-year Treasury bond (the non-inflation-protected kind) have earned compound annual returns of about 6.6%, according to the Federal Reserve.

 

The Consumer Price Index, over the same period, has risen by an average of about 4.4% a year. So standard nominal Treasury bonds have produced “real” yields of about 2.2%.

 

The real yield on five-year TIPS has tumbled and is now below 1%. The seven-year is merely yielding 1.22%, mainly because bond market players are betting on short-term deflation. For regular investors, what matters is that these yields look weak.

 

Today only the 20-year TIPS, with a real yield of nearly 2.2%, looks decent, though not awe-inspiring. But at least you’re guaranteed some return on your money.

 

What’s more, TIPS yields are based on the official inflation rate, which arguably understates true inflation for many people. The higher the “real” yield on your bonds, the greater your cushion.

 

That said, if you do decide to buy, some advice: TIPS can be bought through any broker, and should be kept in a tax-protected account, such as an IRA, because the government taxes both the inflation adjustments and the coupons as income. The main downside risk of buying TIPS is that a sustained period of deflation can cause bond values and coupons to fall reflect falling prices, though you’ll never get less than the real yield. Note, also, that they are bonds, not cash: The price is not fixed at the time of purchase, and can fluctuate considerably.

 

Rather than betting on specific TIPS, many investors choose to hold TIPS in mutual funds. These typically invest in short, medium and long-term TIPS bonds. Vanguard’s Inflation-Protected Securities (VIPSX | fund, and the iShares Barclays Treasury Inflation Protected Securities Bond exchange-traded fund , are both about 70% invested in bonds that mature within ten years or less. With happy timing, bond giant Pimco recently launched an exchange-traded fund that specializes in long-term TIPS, PIMCO 15+ Year U.S. TIPS Index Fund (LTPZ

 

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) , that’s a reasonable choice for investors, with a current yield around 2.2%.

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