TCS Daily


By James K. Glassman - March 5, 2002 12:00 AM

In August 1979, a Business Week cover story pronounced "The Death of Equities." It was terrible timing. The market immediately surged, and the benchmark Standard & Poor's 500-stock index returned 18 percent that year, then 32 percent the year after. The story fired the starter's gun for a raging bull market that lasted, with a few pauses for breath, for 21 years.

Could history repeat? In its March 4 issue a Business Week article pronounced, "Inflation's Gone." The story noted that "core inflation" -- that is, general prices in the economy excluding volatile food and energy -- rose only 2.6 percent last year, despite all the interest rate cutting by the Federal Reserve. And over the past five years, core inflation fluctuated within a narrow band, averaging a few tenths more than 2 percent. By contrast, between 1940 and 2000, the average inflation rate was twice as high. In the 1970s, inflation averaged over 7 percent; in the 1980s, over 5 percent.

Many forecasters have joined Business Week in its conclusion. The Congressional Budget Office, for example, currently projects tame inflation as far as the eye can see: an estimated 1.9 percent in 2002 and then 2.5 percent through 2012.

"The era of price stability . . . is likely to be here for a while," wrote Business Week's Margaret Popper. "Inflation is no longer a factor in long-term decision-making by companies, consumers and investors." Uh-oh.

With all the euphoria about licking inflation, this is a good time to look at a fairly new invention that protects investors against it. The first issue of five-year Treasury Inflation-Protection Securities (TIPS) -- also called index bonds or inflation-linked bonds -- matured in January and the second comes due in July, but there are nine other issues with maturities stretching to April 2032. If your financial strategy calls for bonds, you should consider owning some TIPS -- or their savings-bond equivalent, called "I-bonds."

Do you think inflation is "no longer a factor"? More specifically, do you see it averaging less than 2 percent over the next 10 years? I believe strong new economic forces -- including free trade and technology -- will hold down consumer prices in the future. Still, I advise buying TIPS as a cheap insurance policy.

First, some basics: Bonds are IOUs. They represent a loan that you have made to a corporation or government agency. The loan comes due in full, or matures, at a date fixed when the bond is issued. Meanwhile, you get paid interest twice a year.

Bonds should be used for money that you may need in the next one to five years (10 years at the most), or to throw off income to live on. I prefer Treasury bonds (and highly rated or insured tax-exempt municipal bonds) over corporate bonds, which are difficult to analyze and rarely provide enough extra interest to compensate for the extra risk.

Bonds carry two kinds of risk. The first is credit risk, or the chance that the borrower won't be able to pay you back (or pay interest along the way). With Treasurys, that risk is essentially zero. The U.S. government, with its formidable assets and taxing power, stands behind every bond. The second risk comes from inflation. It's the chance that the dollars you get back when your bond matures won't be able to purchase very much -- and the interest you're paid along the way won't make up for that loss. Stocks also suffer from inflation, but typically not as much as bonds, since companies can raise prices and (they hope) boost profits along with inflation, while most bonds carry a "coupon" -- rates fixed when the loans are made. In the 1970s, for example, Treasury bonds lost an average of 1.9 percent after inflation; large-company stocks lost 1.5 percent; and small-company stocks actually gained 4.1 percent.

Even a relatively small amount of inflation can be devastating over time. If inflation averages 3 percent annually for the next five years, then the $10,000 you pay for a five-year bond today will have just $8,600 in today's purchasing power in 2007. Over 15 years, inflation of 5 percent cuts your purchasing power in half.

That's where inflation-linked bonds come in. They were introduced in Britain in 1981 and have become popular as well in Canada, New Zealand, Australia and some European countries. Finally, under the leadership of Treasury officials Robert Rubin and Lawrence Summers, they were launched in the United States in January 1997. Over the past five years, the Treasury has issued 11 separate series of TIPS with a maturity of five, 10 or 30 years. Each bond carries an interest-rate coupon that varies between 3.375 percent and 4.25 percent -- depending on when the bond was issued -- and each gets an inflation bonus.

The interest on the coupon is paid twice a year, so if you bought a $10,000 bond from the TIPS series that matures on Jan. 15, 2011, and carries a 3.5 percent coupon, you would receive $175 every six months. In addition, the Treasury adds the inflation bonus to the value of your principal. If inflation is 2.5 percent, you get an extra $250 -- but you don't get the bonus until your bond matures (or until you sell it on the open market, which you can do at any time). Currently, the principal on the five-year bond that matures in July amounts to $11,050 for an original investment of $10,000. An investor received $362.50 in annual interest as well.

This system, adopted from Canada, seems overly complicated to me, but think of it this way: TIPS protect you against inflation. You get the coupon rate plus the inflation rate. If inflation soars to 10 percent, a normal bond will be devastated. Who wants to own a bond paying a fixed rate of 5 percent if inflation is 6 percent? With TIPS, you are protected.

TIPS also present a clear alternative to conventional Treasurys. The TIPS that matures in January 2010 was recently offering a real yield of 3.26 percent. A conventional Treasury maturing at the same time was yielding 4.82 percent. Subtract one from the other, and you find that investors are predicting that inflation over the next eight years will average 1.56 percent. That would be the lowest inflation for any eight-year period since the 1950s. If inflation is higher, then TIPS are a bargain compared with Treasurys.

Strangely enough, investors ignored this wonderful invention in the few years after its debut -- perhaps because they were too busy putting their money into tech stocks. But no more. The Treasury has issued more than $100 billion worth of TIPS, including $6 billion at its most recent sale of 10-year bonds in January that carried a coupon of 3.375 percent. You can buy new TIPS straight from the Treasury and already-issued ones on the open market through a bank or stockbroker.

In fact, TIPS have finally become popular enough to merit mutual funds of their own. Vanguard started its Inflation-Protected Securities Fund (symbol: VIPSX) in June 2000 and has already scooped up $900 million from the public. The fund includes nine of the 10 outstanding TIPS issues, with an average real yield of 3.4 percent. Since demand from investors for TIPS has risen sharply over the past two years, the prices of TIPS on the market have risen, too, and, as a result, the Vanguard fund last year returned 7.6 percent -- in both interest and price appreciation, even after expenses to shareholders of 0.25 percent.

The smaller Pimco Real Return Bond Fund (PRTNX), managed by a firm widely considered the best bond specialist in the business, made its debut in 1997. It also invests primarily in TIPS, but with a few foreign inflation-linked bonds (France, New Zealand) and even some corporates tossed in. The fund returned 8.2 percent in 2001 and 13 percent in 2000. The A-shares, however, carry an upfront fee of 3 percent plus annual expenses of 0.94 percent, which is pretty ridiculous. The B shares lack the front-end load but charge expenses of 1.69 percent. Ouch.

The federal government also offers I-bonds, or inflation-protected savings bonds. The most recent series pays 2 percent coupon interest plus a 2.4 percent inflation bonus through April, when the bonus will be adjusted according to the consumer price index. By comparison, you can buy a TIPS bond that matures in 2008 with a real interest rate of 3 percent. Why own an I-bond, then?

Taxes. With an I-bond you can defer taxes as long as you own the bond -- up to 30 years. With TIPS, you have to pay taxes not only on the real interest you put into your pocket but also on the accrued inflation bonus that you won't see until maturity. The interest on both I-bonds and TIPS is exempt from state and local taxes.

Also, if you qualify, you can escape taxes altogether if you use I-bonds to pay postsecondary tuition. But I-bonds have their drawbacks: If you sell in the first five years, you get hit with a penalty of three months' interest. And you can buy only $30,000 worth of the bonds annually. See the Web site for details on both I-bonds and TIPS as well.

What's the worst-case scenario for TIPS? Say that the CPI rises at just 1 percent annually for the next five years. Your TIPS will return about 3.8 percent while a similar straight Treasury will return 4.3 percent. So, even in the unlikely event that the Treasury wins, it won't be by much.

Come on. How can you not own these things?

The article first appeared in the Washington Post.

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