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    TIPS for Inflation-Proofing Your Portfolio: A Guide to Inflation-Indexed Securities

    by Annette Thau

    TIPS For Inflation Proofing Your Portfolio: A Guide To Inflation Indexed Securities Splash image

    In 1997, the U.S. Treasury introduced a new type of bond—Treasury Inflation-Indexed Securities, also known as Treasury Inflation- Protected Securities, or TIPS for short. As their name suggests, these bonds were intended to protect principal against inflation.

    Initially, TIPS met with very little investor interest. But over the past two years, demand has grown and, as a result, a number of mutual fund groups introduced bond funds that are invested primarily in TIPS. In 2002 and 2003, TIPS funds were among the best-performing bond funds. Are these kinds of investments right for you?

    This article discusses TIPS and TIPS funds, as well as a separate, but related, inflation-indexed instrument: I Savings Bonds. The article will address a number of questions: How exactly do TIPS differ from other bonds? What are the factors behind the recent performance of TIPS? Will TIPS continue to outperform conventional bonds?

    Why TIPS Are Unique

    TIPS share a number of characteristics with other Treasury bonds:

    • They are backed by the full faith and credit of the United States government and, therefore, have the highest credit quality;
    • They are sold at Treasury auctions on a quarterly basis;

    • As with other Treasury securities, interest is paid twice a year;

    • Individual investors can buy these bonds directly at auction through the TreasuryDirect program without incurring any commission costs or any cost to maintain their TreasuryDirect account (see www.treasurydirect.gov for more information);

    • TIPS can also be purchased in the secondary market, through brokers, with the customary markups.
    At the present time, the Treasury is selling TIPS only in 10-year maturities, although initially five-year and 30-year maturities were also sold. The distinguishing characteristic of TIPS is that the face value of the bond is adjusted periodically based on the consumer price index for all urban consumers (CPI-U) published by the Bureau of Labor Statistics. Since the CPI-U is announced monthly, there is a lag in the price adjustment of somewhat over one month. Except for this lag, however, over time, the inflation adjustment results in a rise in the face value of the bond at the rate of inflation.

    This inflation adjustment also applies to the coupon interest thrown off by TIPS. The interest rate of TIPS is set when the bonds are sold, at auction. That rate never changes. But because the face amount of the TIPS is adjusted at the rate of inflation, interest income rises as the value of the TIPS rises: The interest income computation is applied to a rising base. Note, however, that interest rates at auction vary as the general level of interest rates varies. Since the time TIPS were introduced, interest rates on the 10-year TIPS at auction have varied from a high of 4.25% at one of the first auctions to a low of 1.87% at the most recent auction.

       How TIPS Work
    To illustrate how the inflation adjustment applies to a TIPS, suppose that you invest $10,000 in TIPS and the interest rate set at auction is 3%. The first interest payment will be ½ of 3% multiplied by $10,000, or $150.00. Now further suppose that the CPI rises by 1½% during the first six months. The value of the principal will now rise by 1½%. The bond will now be worth $10,150. The second interest payment will be based on the increased value of the bond. It will therefore be ½ of 3% multiplied by the new value of the bond: $10,150 or $152.25.

    You may look at these numbers and think: “Big deal! A 3% interest rate and minute adjustments to the coupon don’t amount to very much.” But if you estimate the numbers for a bond with a 10-year maturity, they begin to look a lot more attractive.

    Example:
    3% TIPS with $10,000
    initial face value CPI
    averages 3% per year
    (1.5% every six months) over 10 years
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Assume, for example, that inflation averages 3% a year over the life of the bond. Over that 10-year period, the face value of the bond (that is, its principal value) would rise to approximately $13,440. Interest payments would also rise gradually throughout the life of the bond. When the bond matures, instead of the $10,000 you invested, you would redeem the bond at its appreciated face value at that time, that is, $13,440. In addition, interest income would rise gradually until, during the 10th year, coupon payments would have increased to about $201.50 twice a year (or $403.00 annually). Total return on that bond would consist of the interest payments you would have received, plus the additional $3,440 adjustment to principal that you would receive at maturity. The entire amount would add up to somewhere between 6% and 7½% annualized return under those assumptions.

    TIPS vs. Conventional Bonds

    In theory, TIPS sound like very simple and predictable instruments. It was assumed, for example, that because of the inflation adjustment, TIPS would be less volatile than conventional bonds. It was also assumed that TIPS would perform better during periods of rising interest rates than during periods of declining interest rates.

    But the actual price performance of TIPS has not matched these expectations. When they were initially issued in 1997, TIPS met with very little investor interest. Their price declined for a couple of years. In 1999, interest rates rose, but TIPS experienced significant price declines. During 2002 and 2003, interest rates generally declined, with some ups and downs, but TIPS and TIPS funds soared.

    To analyze this further, let’s compare the performance of two Treasuries with identical maturities: one a 10-year TIPS, and the second a conventional 10-year T-note (any bond with a maturity of two to 10 years is called a note).

    Table 1, below, shows TIPS rates listed in the New York Times on December 25, 2003, in its daily Key Rates Table. Shorter and longer maturities are included as background for the level and direction of interest rates.

    Table 1. Treasury Rates
      12/24/03 12/24/02
    10 yr. TIPS 1.93% 2.30%
    10 yr. T-note 4.19% 3.90%
    30 yr. T-bond 5.06% 4.86%
    6-month T-bills 0.985 1.22%

    Table 1 illustrates several different aspects of TIPS cash flows and performance.

    Comparing Yields
    First, suppose you are wondering whether to buy the 10-year TIPS or the 10-year Treasury note. At first glance, the yield of the TIPS (1.93%) appears a good deal lower than that of the 10-year T-note (4.19%). The conventional 10-year T-note, in fact, appears to have a yield advantage of 2.26% (226 basis points). But remember that the two yields are not equivalent.

    The 4.19% yield of the conventional T-note is called the nominal rate. This nominal rate actually consists of two separate components: an implicit inflation rate and an interest rate payment. If you subtract the inflation rate from the nominal rate, the resulting number is what is called the real rate of return of the bond, that is, the rate of return after accounting for inflation. In this example, if you subtract the current rate of inflation (around 2%) from the 4.19% nominal rate of the conventional 10-year T-note, you get an estimated real rate of return of 2.19%.

    Can you determine, based on these numbers, which is the better buy?

    The answer to that is: You don’t know and you can’t know at the time you purchase the bond. That’s because the 1.93% yield of the TIPS does not include the inflation adjustment that will be applied monthly to the price of the TIPS. It may be higher than 2% or lower, depending on the future inflation rate.

    In order to compare potential returns of TIPS to those of conventional bonds under different inflation scenarios, analysts have introduced a concept known as the breakeven rate. The breakeven rate is defined as the rate that would result in equivalent total returns for both types of bonds. In this example, the difference between the rate of return of the TIPS and that of the 10-year note is 226 basis points.

    If inflation turns out to equal exactly 2.26%, then the total return of each bond will be equal.

    If the rate of inflation turns out to be higher than 2.26%, then due to the inflation adjustment, the TIPS will turn out to be the better buy. But if the rate of inflation is lower than 2.26%, then because of higher interest payments during the life of the conventional T-note, that will turn out to have been the better buy.

    Of course, at the time you purchase a bond, you cannot predict the future rate of inflation.

    Comparing Performance
    Table 1, however, shows another important aspect of the two bonds—namely, how the yield of the two bonds changed over the past year.

    The first thing you notice is that long and short rates moved in opposite directions: The shortest rate—six-month T-bills—actually declined, whereas rates of both the 10-year and the 30-year conventional bonds went up.

    But what is particularly striking is that the yield of the 10-year T-note and that of the 10-year TIPS—with identical maturities—also moved in opposite directions. The yield of the 10-year T-note rose from 3.90% to 4.19%, an increase of 29 basis points; whereas, the yield of the 10-year TIPS decreased from 2.30% to 1.93%, a decline of 37 basis points. That represents a spread of 66 basis points.

    Since this one-year period was a time of low inflation, with the Federal Reserve holding the federal funds rate at 1%, and the rate of the six-month T-bill declining from 1.22% to under 1%, you might have expected that this would be a poor time to invest in TIPS. But instead, the decline in the yield of the TIPS resulted in the price of that security appreciating, whereas the price of the 10-year conventional note declined due to the rise in yields. (Remember that the price of TIPS, like that of other bonds, moves inversely to the direction of interest rates: When interest rates decline, the price goes up; when interest rates rise, the price declines.)

    Why TIPS went up during a time of low inflation is not totally clear. One answer has to be that TIPS went up because of greater demand. Another possibility is that the greater demand was due not so much to the actual inflation picture, as to expectations that inflation would rise in the future, perhaps because yields were so low.

    But what is evident is that, over the short term, market forces such as investor demand, as well as anticipation of future inflation, may play a larger role in the price performance of TIPS than the inflation adjustment.

    So to get back to the original question: Which is the better buy, the 10-year TIPS or the conventional 10-year T-note? The only statement that can be made with certainty is that ultimately, over very long holding periods (10 or more years) the total return of TIPS will parallel the inflation rate. But TIPS will outperform conventional bonds only if inflation is higher than the breakeven rate over these holding periods. Over short periods of time (say one or two years), there is no way to predict which will have a higher total return.

    In the event deflation were to occur, TIPS enjoy a measure of protection: The Treasury guarantees that if you hold a TIPS until it matures, its price will not be below the original price of the bond at auction. But while it trades in the secondary market, the price of a TIPS fluctuates on a daily basis, both up and down, and may decline below its face value.

    TIPS Mutual Funds

    Between December 2002 and June 2003, a number of TIPS mutual funds posted returns for the preceding one-year period that were as high as 15% to 19%. In absolute terms, these were stellar returns. But in addition, these returns exceeded those of intermediate (and longer) Treasury funds—the most appropriate comparisons for both credit quality and maturity—by as much as 2% to 5% for corresponding periods. This generated a spate of articles about TIPS and TIPS bond funds.

    Keep in mind that TIPS funds remain a very small corner of the bond fund universe. TIPS bonds initially generated very little investor interest, and consequently, mutual fund companies were slow to offer TIPS funds. Only five TIPS funds have histories that go back as far as three years, and at the present time only a few mutual fund groups offer TIPS funds.

    But if you are wondering whether to invest in TIPS funds because of their stellar returns over the past two years, several notes of caution are in order.

    First, of course, is that the returns posted for TIPS funds, like those of any other bond fund, are total returns, consisting of both interest income and changes in net asset value. Since the interest income posted for TIPS bonds has varied between approximately 2% and 4%, it is clear that the high total returns of TIPS funds were due primarily to an increase in the net asset value of the funds, deriving from steep declines in interest rates. Given the current low level of interest rates, declines of a similar magnitude are unlikely to recur.

    But this question has a separate component, which is why the return of TIPS funds exceeded that of bond funds invested in conventional Treasuries with comparable maturities. One answer is suggested by the rate changes we saw in Table 1, which showed that TIPS interest rates declined during 2003, whereas those of the 10-year T-note went up. That would have caused the net asset value of a TIPS fund to go up and the net asset value of a conventional bond fund to decline.

    But another answer is simply that TIPS bonds, and consequently TIPS funds, are more volatile than conventional bonds and conventional bond funds. What that means is that for any given change in interest rates, whether up or down, there is a greater change in the price of TIPS bonds (and consequently of TIPS funds) than for conventional bonds. This has important implications in the event that interest rates reverse direction and start going up. In that eventuality, just as TIPS bond funds had higher total returns at a time of declining or low interest rates, they may have significantly lower returns in a rising interest rate environment.

    This statement also needs some qualification. One needs to distinguish between the long term (really long term) and the short term. Ultimately, if there is a long period of several years or more with rising interest rates and rising inflation, over time, returns of TIPS bonds and TIPS funds should track the rate of inflation. But if interest rates begin to rise some time in the future, and continue to rise, then during that initial period, which might last for a number of years, returns of TIPS bonds (and TIPS funds) could be significantly lower than those of conventional bonds (and funds). Of course, we will not know that for certain until such a period actually occurs.

    TIPS funds are offered by both load and no-load fund families. Some TIPS funds pay interest quarterly, rather than monthly. The inflation adjustment in the price of TIPS bonds is reflected in daily changes in net asset value. But mutual fund groups may also make periodic adjustments based on inflation adjustments announced by the Treasury.

    The usual caveats would apply: If you are buying TIPS through funds, I would suggest that as a first cut, you investigate no-load funds with low expense ratios.

       And Now ... A TIPS ETF
    On December 5, 2003, Barclays Global Investors announced the start of trading for the first exchange-traded fund (ETF) in TIPS (ticker symbol, TIPS). This exchange-traded fund will be benchmarked to the Lehman Brothers TIPS index. Its expense ratio will be approximately 20 basis points, and returns would be expected to track those of the index. The price of shares is posted every 15 seconds, but price changes are unlikely to occur that often, because bond prices do not change that quickly.

    Like any exchange-traded fund, shares can be purchased through any brokerage firm, and commissions would be the customary commissions for purchasing stocks. There are no minimum or maximum amounts.

    Taxes

    The tax treatment of TIPS resembles that of zero-coupon bonds. The face value of TIPS is adjusted periodically. If you buy a TIPS at auction, and hold it until it matures, the inflation adjustments will not be paid out until you redeem the bond at maturity. But you will be taxed annually on the adjustments. That is sometimes called a tax on “phantom income.”

    If you hold TIPS in a bond fund, you will also be taxed annually on the inflation adjustments. If you are in a high tax bracket, that feature might make these bonds suitable primarily for tax-deferred or tax-advantaged accounts. Note, also, that income from TIPS is not taxable at the state and local level, but it is taxable at the federal level.

    I Savings Bonds

    I Savings Bonds are a totally separate and distinct vehicle for protecting fixed-income investments against inflation. They are the newest and most attractive of the savings bonds.

    I Bonds are accrual securities, which means that you do not receive interest payments (coupon income) until you redeem the bonds. But taxes on interest can be deferred until the bonds are redeemed or until maturity—that is, for up to 30 years. In addition, interest income is exempt from state and local taxes.

    Like TIPS, I Savings Bonds offer inflation protection. The earnings rate of I Bonds is a combination of two separate rates: a fixed rate of return, and a variable semiannual inflation rate. The fixed rate is set when the bonds are initially sold, and it remains the same throughout the life of the bond. But the semiannual inflation rate adjustment is reset every six months, based on the CPI-U.

    In the unlikely event that deflation were to occur, the value of the bond would remain at its pre-deflation level. The combined rate does not simply add the two rates: They are combined according to a complex formula explained on the Treasury’s Web site.

    I Bonds have several major advantages:

    • First, like TIPS, the value of the I Bonds rises at the rate of inflation.

    • Furthermore, the interest rate set at the time of issue guarantees a minimum return.

    • Most importantly, however, because I Savings Bonds do not trade in the secondary market, the value of I Bonds can never go down. The value of TIPS, on the other hand, fluctuates in the secondary market and could conceivably decline below the issue price.
    I Bonds are sold for face amounts ranging from $50 to $10,000. They are purchased at face value: You pay $50 for a $50 bond. You can buy up to $30,000 worth of I Bonds each calendar year.

    I Bonds can be bought directly through the Internet at the Treasury Web site, at a local bank, or through an employer-sponsored plan such as EasySaver. I Bonds have a maturity of 30 years, but they can be redeemed any time after 12 months.

    Because these bonds are structured primarily as long-term investments, there is a small penalty for redeeming I Bonds within five years of purchase: You would forfeit three months of interest if you cash out your bonds within five years.

    In February of 2000, I Bonds were being sold with a combined interest rate of 6.98%. That is a combination of a fixed rate of 3.4% and an inflation-adjustment rate of about 3.5%. The current combined rate is the lowest in the history of the program: 2.19%.

    Since the inception of the program, during most years the fixed rate has been between 3.5% and 4% and the inflation adjustment between 2% and 3.5%, for a combined rate of around 6% to 7%. Older bonds are continuing to earn the higher interest rate. The combined rate is likely to rise from current levels if inflation and interest rates rise.

    Conclusion

    The main attraction of any of the instruments discussed in this article is that they provide a hedge against future inflation and insure a modest, but real rate of return over long holding periods. Whatever the size of your bond portfolio, it would appear prudent to place a portion of that portfolio in one or more inflation-protected investment.

    Any discussion of TIPS, however, has to distinguish between long-term (10 years or more) and short-term holding periods (a couple of years). Over the long pull, the total return of TIPS will track inflation and generate a real rate of return that parallels inflation. Whether that turns out to be higher or lower than conventional bonds will depend on the actual course of inflation.

    Over shorter time periods, say one or two years, changes in the price of TIPS are correlated not so much with actual conditions of inflation, as with expectations of inflation, as well as demand. This is true even though actual physical adjustments in price and coupon income occur at all times.

    Over the past few years, TIPS have been more volatile than conventional Treasuries; i.e., changes in interest rate levels have generated larger price moves for TIPS, either up or down, than for conventional bonds with comparable maturities. This raises the possibility that if interest rates rise at some future date—a not unlikely occurrence given the current level of interest rates—then TIPS bonds (and bond funds) may underperform—that is, experience larger price declines than—conventional bonds.

    If you are wondering which instrument is better suited for your own objectives, a few points may be useful.

    • Because of their tax consequences, TIPS and TIPS funds are best held in tax-deferred accounts.

    • The TIPS exchange-traded fund offers a low-cost method for investing in TIPS that will track the performance of a TIPS index. But note that the commission levied on each purchase would make this a poor choice for investing small sums periodically. No-load TIPS mutual funds would be a better choice for investing small sums in TIPS regularly.

    • If you plan to invest larger amounts, the most attractive way to invest would be to buy TIPS at auction through the TreasuryDirect program. This enables you to build up a portfolio of TIPS tailored to your needs, while avoiding all commission costs or any management costs of your account.

    • I Savings Bonds offer several distinct advantages. Since no taxes are payable until the bonds are actually cashed in, they are extremely attractive for building up savings for retirement outside of tax-deferred accounts. The education exclusion also offers an attractive method of saving for future college expenses. A further attraction of I Savings Bonds is that the value cannot go down since they do not trade in the secondary market.

    • Timing, as always, is an issue. But if you are purchasing any of these instruments as a long-term hedge for part of your bond portfolio then timing ceases to be an issue. Also, while current interest rates are low, by making periodic investments (say, on an annual basis), you would be taking advantage of both rising interest rates as well as the inflation adjustment.
       What a Deal! I Savings Bonds for Retirement and Education
    Have I got a deal for you! I’m going to offer you a retirement plan with the following features:
    • You can invest any amount, from $50 to $10,000, and invest up to $30,000 per calendar year.

    • The amounts invested will accrue interest at a guaranteed minimum rate set at the time you buy, but an additional interest component will be added, which will be reset every six months, based on the inflation rate. In the event deflation occurs, the minimum interest rate will remain in effect. In the event interest rates rise, the value of this bond (unlike that of any other bond, including Treasuries, that trade in the secondary market), will not decline.

    • Interest and interest-on-interest will compound, tax deferred, until you choose to cash in some bonds for income or for any purpose you choose. You can cash out any sum you wish, any time you wish, after 12 months. But you can also leave the money to compound for up to 30 years. Both purchases and withdrawals can be tailored to your needs.

    • Interest income is exempted from state and local taxes.

    • The credit quality of these bonds is of the highest quality. There is zero default risk.

    • You can buy these securities at no cost—no commissions of any kind. Furthermore, the organization that sells you these bonds will maintain your account free of charge to you.

    • You can buy these bonds in the privacy of your home, via the Internet. You can also set up an automatic withdrawal plan through your employer, or you can buy these bonds from your local bank.
    Sound too good to be true?
    I have just repeated all the features of I Bonds. They bear repetition because this product is a sleeper: Obviously, brokerage firms do not recommend I Bonds even if they could sell them because they can’t make any money on them. Banks are unlikely to push I Bonds because they compete with CDs and because banks don’t make any money selling you I Bonds. But if you compare the features of I Bonds to those of other products designed to provide tax-deferred income, such as annuities, for example, I Bonds are likely to be the superior product.

    Education
    Another attractive feature of I Savings Bonds is that they qualify for the education tax exclusion. If the proceeds from I Savings Bonds are used to pay qualified college expenses, no federal taxes are due. (Qualified expenses include college fees and tuition; they do not include room and board, books, and other miscellaneous expenses.)

    Note, also, that to be eligible for the tax exemption, a number of additional provisions must be met: The bonds must be bought in the name of the parent and income caps apply. These are reset and pegged to the rate of inflation. Full details of the program are somewhat complex, but the program is attractive enough to be of interest to most families in the middle-income brackets.

    Hot link:
    For complete information on this program and I Savings Bonds in general, the best source of information is the Web site maintained by the Treasury at www.publicdebt.treas.gov/sav/sbiinvst.htm.


    Annette Thau, Ph.D., is author of “The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More,” (copyright 2001, published by McGraw-Hill; $29.95). She has spoken to AAII chapters in different parts of the country about bonds and bond funds.

    Ms. Thau is a former municipal bond analyst for Chase Manhattan Bank. She also until recently was a visiting scholar at the Columbia University Graduate School of Business.


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