But Treasury Securities Tied to Consumer Prices Carry Their Own Risks

Annelena Lobb

Updated Sept. 23, 2009 8:36 p.m. ET

Rising fears of inflation are fueling an investor rush into mutual funds and exchange-traded funds holding Treasury inflation-protected securities.

So far this year, more than $17 billion has poured into funds that invest in TIPS, government-issued bonds whose principal grows with rising inflation, according to estimates from research firm Morningstar Inc. That compares with estimated net cash inflows of almost $10 billion for 2008.

Their popularity reflects worries that massive U.S. government spending will eventually lead to high inflation, which could erode the value of stocks and ordinary bonds. But if inflation stays at current low levels longer than some investors expect, TIPS may not add much juice to a portfolio—and could even drop in value.

That said, many investors aren’t in it for the yields, but for the protection they hope the bonds will provide if inflation suddenly surges. For now, TIPS buyers are brushing aside the prospect that the bonds won’t do well if that much-feared inflation doesn’t materialize. Indeed, many TIPS have been bid up to prices exceeding their face value.

Total net assets for TIPS-focused mutual funds and ETFs were approximately $51 billion at the end of 2008. The mutual funds have gained an average 7.4% total return this year through Sept. 21, according to Morningstar. That showing, while nothing like the dizzying run-up in junk bonds, is much better than that of ordinary government bond funds, which have returned 2.6% so far this year.

Tips on Buying TIPS

Treasury inflation-protected securities—government bonds whose principal rises in value with inflation—are growing in popularity. Here are three ways investors can invest in them:

Individual TIPS: The bonds can be bought from a bank or broker, which may charge a transaction fee. Investors who buy bonds directly from the government via TreasuryDirect.gov avoid paying fees. One downside: Gains to the principal aren’t distributed until maturity, although taxes are due annually.

TIPS mutual funds: Actively managed TIPS funds give investors diversification, since the portfolios often hold bonds with various maturities. As with all mutual funds, they charge management fees, although many are low. Gains are distributed to investors’ accounts regularly, instead of at maturity.

TIPS exchange-traded funds: ETFs are index funds that can be easily and quickly traded on an exchange, a key advantage over traditional mutual funds, which take longer to get in and out of. ETFs typically offer the same advantages as mutual funds, and their fees may be lower.

Source: WSJ research

Richard Seelig, a retired high-school math teacher in Pelham, Mass. bought shares of the iShares Barclays TIPS Bond Fund last December for his Roth individual retirement account. I looked at the amount of money the government was spending that it didn’t have, and I thought, well, that is going to come back to haunt us, he says. The Barclays fund, an ETF, has gained 8.2% this year through Sept. 21.

TIPS pay a fixed interest rate every six months, known as a coupon, similar to ordinary Treasurys. But unlike Treasurys, TIPS’ principal value fluctuates with the inflation rate. Over the life of the bond, increases in the value of its principal aren’t paid out, although investors who own TIPS outside of retirement accounts do pay taxes on any interim gains on the principal, as well as on any interest.

When the bond reaches maturity, the inflation-adjusted principal is returned to investors. (If deflation were to occur, the adjustments to the principal would be negative, though a TIPS bond held to maturity will never return less than its original principal.) TIPS mutual funds, by contrast, pay out interest and principal gains on a regular basis. Like Treasurys, TIPS are exempt from state and local taxes.

TIPS are issued in maturities of five, 10 and 20 years. A plain-vanilla 10-year Treasury currently yields about 3.5%, while a 10-year inflation-protected security yields about 1.6%, before inflation. The yield gap between 10-year TIPS and Treasurys, now about 1.8 percentage points, is called the break even rate and implies an expected annualized inflation rate of about 1.8% over 10 years. If inflation averages more than 1.8% over the period, then TIPS will outperform standard Treasurys. The lower the break-even rate is, the easier it is for TIPS to outperform the regular variety Treasury.

Supply and Demand

But inflation alone doesn’t determine how well TIPS perform. Supply and demand also play a role. And demand for TIPS is driven by inflation expectations, rather than actual inflation. Such expectations could drive TIPS prices higher, thereby shrinking yields, since price and yield move inversely.

There has been a ton of money flowing into TIPS year to date, yet there’s no inflation, says Lawrence Glazer, managing partner at Mayflower Advisors in Boston.

Instead, money keeps pouring into the investments based on the expectation that inflation is ahead.

If the break-even rate widens, that would imply investors foresee higher inflation. But once the Federal Reserve begins to address inflation, it will raise short-term interest rates, and that would push down the value of existing bonds.

In that case, there would be two counterforces acting on TIPS: rising inflation or expectations of inflation pushing up demand and thereby pushing up prices; and rising short-term rates driving down prices. If the Fed pushes rates up faster than inflation rises or raises rates before inflation picks up, TIPS could rack up losses for their owners. They could also decline if inflation turns out milder than investors’ original expectations.

Wait and See

Some investors say they want to wait to buy TIPS until they actually start to see the Fed raise interest rates, says Debra Brede, who runs D.K. Brede Investment Management Co. an investment-management firm in Needham, Mass. The risk: If inflation is already escalating when investors decide to buy TIPS, the bonds might be more expensive at that point, she says.

Of course, given the anemic economy and high joblessness, any resurgence in inflation may be distant. Certainly not in the next couple quarters, says John Canavan, a research analyst at Stone & McCarthy Research Associates in Skillman, N.J.

Fed Statement

On Wednesday, the Federal Reserve announced that it decided to leave interest rates unchanged. In its accompanying policy statement, the Federal Open Market Committee noted that it expects that inflation will remain subdued for some time.

One caveat is that TIPS, which have been around only since 1997, don’t have a track record during a period of sustained high inflation.

Investors do have some other choices. If both inflation and economic growth are high, assets such as commodities and equities could outpace TIPS, says Dan Dektar, chief investment officer of Smith Breeden Associates’ investment management group in Durham, N.C.

Buying Direct

Investors can buy TIPS directly from the U.S. Treasury at TreasuryDirect.gov without incurring brokerage fees; some brokerage firms also allow clients to purchase new-issue or secondary-market TIPS without incurring fees. The next TIPS auction is for bonds with a 10-year maturity and is scheduled for Oct. 5.

Many planners recommend that individual investors hold TIPS in retirement accounts, particularly if the client is in a higher tax bracket.

TIPS are not tax-friendly, said Doug Flynn, a certified financial planner at Flynn Zito Capital Management in Garden City, N.Y. You’re not buying these for tax efficiency, you’re buying because you’re scared of inflation.

For those who prefer mutual funds, which provide diversification and professional management, there are a variety of funds that invest in TIPS and a handful of exchange-traded funds. Allianz SE’s Pacific Investment Management Co. or Pimco, has unveiled three new TIPS ETFs this year, targeting different maturities.

One popular TIPS mutual fund is Vanguard Group’s Inflation Protected Securities Fund, which aims to outdo the Barclays Capital U.S. TIPS Index and has about $25 billion in assets under management. The fund distributes both interest and any inflation adjustment to the principal on a quarterly basis, though most investors choose to reinvest distributions, said Ken Volpert, who heads Vanguard’s taxable bond group and co-manages the fund. Keep in mind, though, there are circumstances in which an income distribution may not occur, such as when the rate of deflation exceeds the yield before inflation.