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It's very wise to include bonds as a part of your portfolio.

Suppose bonds were purchased at par for $100,000 and held for 10 years when inflation was 3.5 percent per annum? At maturity, the investor would receive the final interest payment and the face value of the bonds — $100,000. However, if these were Treasury Inflation-Protected Securities (TIPS), the investor would receive at maturity the inflation-adjusted face value of $141,106. Let's explore this further.

Background: Judy Day, RN, and her husband, Michael, are five years away from retirement. They accumulated a considerable nest egg in their 401(k) and taxable accounts and are both in excellent health. Judy and Michael are baby boomers and expect social security benefits will eventually be cut. Their primary goal is to not outlive their financial assets. Their primary risk is inflation since most of their retirement income is fixed-not adjusted for changes in inflation. Will TIPS provide the inflation protection they need?

What are TIPS?
The following is a summary of key provisions of these securities.
1. The interest rate is set and remains fixed throughout the term of the security.
2. The principal is adjusted for inflation every six months, but the inflation-adjusted principal will not be paid until maturity.
3. Semiannual interest payments are based on the inflation-adjusted principal at the time the interest is paid.
4. At maturity, the securities will be redeemed at the greater of their inflation-adjusted principal or par value amount at original issue.
5. Like all United States Treasury securities, principal and interest payments of TIPS are backed by the full faith and credit of the United States government. (Inflation is measured using the CPI-U Index, the best known and most widely accepted measure of inflation.)

As an example of how it works, suppose on January 15 an individual invests $100,000 in new 10-year TIPS with a 2.8 percent interest rate (the real rate of return). If actual inflation was 1.8 percent during the first six months, then by July 15, the inflation-adjusted amount of the security would be $101,800. In addition, on July 15, the investor would receive the first semiannual interest payment of $1,425 ($101,800 times 2.8 percent divided by 2). Suppose inflation reached 3 percent for the first full year? By the end of the second semiannual interest date, the inflation-adjusted principal amount would be $103,000 and the interest payment would be $1,442 ($103,000 times 2.8 percent divided by 2).

TIPS Performance
For rolling four quarters from March 1997 through March 2005, Lehman Brothers and Bloomberg reported returns for TIPS (and United States Treasury bonds) were minimum 1.9 percent (-.8 percent), maximum 18.1 percent (12.5 percent), and average 8.3 percent (7.6 percent). TIPS returns have shown negative correlation with equities and Treasuries. Thus, including TIPS in a balanced portfolio will reduce its volatility. Historically, equities have been considered a good inflation hedge. Yet, data from Barclays Capital and Bloomberg shows that TIPS are even better.

Tax and Other Considerations
For federal taxes, the semiannual interest payments are taxable. Also, the inflation adjustments to principal are taxable, even though the principal payments will not be received until maturity (a situation sometimes described as "phantom income"). Like all securities issued by the United States Treasury, TIPS are exempt from all state and local income taxes. For individuals, it is best to hold TIPS in a tax-deferred account such as in a 401(k) or IRA.

The best time to buy TIPS is when inflation expectations are up and the growth of the economy is slowing ("stagflation"). High inflation creates higher inflation-adjustment value of the TIPS and higher semiannual interest payments. The worst time to buy TIPS is when inflation expectations are down and productivity growth is up — a period when inflation is expected to be low. Contrary to our normal way of thinking about bonds, with TIPS, high inflation is good and low inflation is bad.

I did an analysis of 10-year TIPS versus 10-year regular United States Treasury bonds. Using the yields-to-maturity at the most recent Treasury auctions, I calculated that returns for each would be identical if inflation in the next 10 years averaged 2.26 percent a year. For the period 1926-2002, inflation averaged 3.14 percent per annum. Jimmy the Greek would certainly say the odds the inflation rate in the next 10 years will exceed 2.26 percent (favoring TIPS) are well above 50 percent.

Over $300 billion is invested in TIPS. This is a large amount, but it is a very small part of the overall bond market. When buying TIPS in the open market with its lesser liquidity and fewer participants, the investor may face relatively large bid-ask price spreads. To avoid this, you should buy TIPS at auction through your broker for a small flat fee. Or, individuals can buy TIPS directly from the United States Treasury at no cost. Google "Treasury Direct" to learn more.


Summary
TIPS held in a tax-deferred account provide good returns and diversification benefits with their low correlations with equities and other bonds. TIPS provide extremely important insurance protection against high inflation at virtually no cost. With a net $900 billion trade deficit and a federal deficit of $248 billion in 2006, does this portend higher inflation in the future?

Next month: Bonds


May 2007

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