May 25, 2003

Inflation hasn’t been a problem for the U.S. economy for years and it is not thought to be a threat now. In fact, Federal Reserve Chairman Alan Greenspan recently turned heads by talking about the risk of deflation. Still, a growing number of investment advisers and financial economists are urging investors to put a portion of their assets into inflation-proof bonds.

Why invest in such bonds when there isn’t much to protect against? These bonds, issued by the U.S. Treasury and commonly known as TIPS, have been around for more than five years — long enough for financial analysts to determine that their prices behave differently than stocks and other bonds. That makes TIPS their own asset class, and adding them to a portfolio of stocks and bonds should lower risk and enhance returns.

Here’s how TIPS work: Like conventional bonds, inflation-proof bonds pay interest. Today, a 10-year TIPS yields 1.9%. That’s 1.7 percentage points less than the 3.6% you’ll get with a 10-year U.S. Treasury note. So why buy TIPS? Twice a year, the principal will be increased to offset any rise in inflation.

Say you paid $1,000 at the beginning of the year for a TIPS bond that carries a 3% coupon. If the consumer price index for urban consumers remains at its current 3%, the bond’s principal will be boosted to about $1,030 by yearend. When adjusting TIPS for inflation, the Treasury uses the inflation rate for urban consumers, not the so-called core rate, which is currently 1.7%. The $30 gain, plus the 3% interest, would translate into a total return of 6%. In contrast, the regular Treasury bond will pay its coupon rate, which is about 4.4% for a 10-year note. Better still, next year’s interest payment on the TIPS will be 3% of the new $1,030 principal.

If inflation continues at its current 3% rate, TIPS will outperform regular Treasury bonds. In fact, as long as inflation remains greater than 1.7% — the difference between the regular Treasury’s 3.6% yield and TIPS’s 1.9% — TIPS are the better bet. However, if deflation becomes a problem, regular Treasuries will do better, given the difference in yields. Even though the TIPS principal is adjusted upward when inflation rises, there’s no reduction if deflation kicks in. Like all U.S. government securities, TIPS are guaranteed to return 100% of principal at maturity.

Even with a benign inflation rate, TIPS have paid off for investors, giving them a higher return without increasing overall risk. Consider an investor who has had 60% in stocks and 40% in bonds over the past five years. Investment adviser Ronald Rog. president of R.W. Rog? & Co. in Bohemia, N.Y. says an investor who put half of the bond allocation in TIPS would have improved returns by an average 0.45 percentage points a year without ramping up the portfolio’s risk level. That’s dramatic, he says. If inflation kicks up again — and some fear a growing budget deficit and weakening dollar will cause that — the return from TIPS will be greater.

TIPS offer diversification benefits because they behave in a fundamentally different way than stocks and other bonds. For example, when inflation spikes or just rises a little more than expected, stocks and bonds generally suffer — you need only look back to the inflationary 1970s to see that. But because TIPS are designed to keep pace with increases in the cost of living, they help offset losses elsewhere in the portfolio. Every time there has been a tiny uptick in inflation in the past five years, TIPS have done well, says P. Brett Hammond, director of portfolio studies at TIAA-CREF Investments. Indeed, although Treasuries rallied last year, TIPS did even better, in part because inflation rose from 1.6% in 2001 to 2.4% in 2002.

TIPS perform well for reasons other than inflation, too. As with conventional Treasuries, TIPS prices benefited from interest-rate reductions and investors’ flight from stocks in the wake of poor corporate earnings reports, says Dan Bernstein, research director at Bridgewater Associates in Westport, Conn. Last year, TIPS returned 16.4% as the Standard & Poor’s 500-stock index fell 22%.

So, how much of your portfolio should be in TIPS? Rog? recommends 15% to 35%, depending on your age or appetite for risk (table). A good way to gauge your risk tolerance is to calculate how much you would need to save each year using TIPS alone. Indeed, funding retirement through TIPS is risk-free — your principal is secure as long as you hold your bonds until maturity, and you’re guaranteed to keep up with increases in the cost of living.

Consider a 35-year-old man earning $150,000. To keep his current standard of living, he needs the equivalent of $105,000 a year in today’s pretax dollars over a projected 25 years of retirement. To do that with TIPS, he must save about $45,000 a year in each of the next 30 years, calculates Zvi Bodie, a Boston University finance professor and co-author of Worry-Free Investing (FT Prentice-Hall, $24.95). You can crunch the numbers yourself if you download Bodie’s calculator at prenhall.com/worryfree.

Forty-five thousand dollars? That’s far more than most people earning $150,000 can save. But that is just the worry-free benchmark. The further you get from $45,000, the more risk you have to take to reach your financial goals. As you age and are able to save more money, your strategy would be to increase the TIPS allocation.

Buying TIPS is easy. You can place a minimum $1,000 order without commission via the TreasuryDirect program (www.publicdebt.treas.gov/sec/sectrdir.htm, or 800 722-2678). You can also buy mutual funds that invest in TIPS. American Century, Fidelity, and Vanguard offer no-load funds with expense ratios below 1%. TIPS are best purchased in a tax-deferred account. Otherwise, you’ll have to pay federal income taxes each year on their interest, as well as the amount by which the principal increases for inflation — even though you won’t see a dime of the latter until the bond matures or you sell it.

If you want to invest with aftertax dollars, you might opt for IBonds, inflation-adjusted U.S. savings bonds. Their regular interest payment is less than TIPS’ — currently, it’s 1.1%. But you’ll owe no taxes until you sell or the bond matures. With IBonds, you can invest no more than $30,000 a year and must lock up your cash for a year. Moreover, those who sell before five years forfeit three months’ interest. That’s a small price to pay for an investment that offers to protect your purchasing power.

Corrections and Clarifications

TIPS for your portfolio (BusinessWeek Investor, May 26) stated that even though the TIPS principal is adjusted upward when inflation rises, there’s no reduction if deflation kicks in. The article should have stated that while there is no reduction to principal over a TIPS’s lifetime, there would be a short-term reduction if deflation occurs. If held until maturity, TIPS are guaranteed to return 100% of principal.