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Stock investors often are loath to consider bonds, which seem dull and are exposed to their own batch of hard-to-measure risks. Right now though, a certain type of bond strikes me as offering a tempting balance of risk and reward for long-term investors. These are the U.S. Treasury's Inflation-Indexed Securities, better known as TIPS (for Treasury inflation-protected securities).
TIPS are built to withstand inflation by guaranteeing investors that the bond's principal will move in sync with changes in the consumer price index. With inflation effectively neutralized, an investor buying TIPS today can count on a 4% real ("real" in this context is econo-speak for "after inflation") return with nil risk. Over long periods, stocks have averaged a real return of 7%. That's a lot higher than 4%, but at much greater risk.
Holding bonds directly can be cumbersome for individuals, yet a few mutual funds focused on TIPS have sprung up. American Century Inflation-Adjusted Treasury and Pimco Real Return Bond (PRRDX) have been operating since 1997, when the Treasury first issued TIPS.
The cheapest of the funds, with an expense ratio of just 0.25%, opens for business this month. It's called Vanguard Inflation-Protected Securities Fund. To learn more about it, I reached managers John Hollyer and Ken Volpert by phone at their suburban Philadelphia office. Edited excerpts of our conversation follow:
Q: What kind of individual investor should be interested in this fund?
Hollyer: It could fit into anyone's risk mix, in various weightings. I think it will probably be used more by conservative investors interested in preserving their purchasing power.
Volpert: It also makes sense for investors who aren't even looking for inflation-protected income but are looking for a diversified asset in their mix.
Q: Many investors might have an asset allocation of, say, 60% equities and 40% bonds. This could make up the 40% bonds?
Volpert: This could make up a big chunk of the 40% [asset allocation of] bonds. It won't totally diversify away [the risk in noninflation adjusted] bonds, but it will allow for an even greater equity weight. You might go to 65% stocks, 35% bonds, blended with TIPS and nominal bonds.
Q: Is that because you don't have the credit risk of corporate bonds that you might have in a typical portfolio?
Hollyer: Not really. It's more that TIPS's performance as an asset class is not well correlated to nominal bonds or stocks.
Volpert: It becomes another low-correlated asset class.
Q: How much do TIPS pay currently, and what's the assumed inflation in them?
Hollyer: Currently, TIPS have real yields stretching from just about 4% up to about 4.25%.
Volpert: If inflation over the next 10 years is 2.2% or greater, the TIPS should do better than the [ordinary Treasury] bond for that period. That's a pretty low inflation rate, given where we are right now and what kind of inflation we've been experiencing. So, for investors who think that 2.2% over the next 10 years is a pretty low rate, inflation-indexed bonds might make some sense.
Hollyer: The analogy is buying flood insurance in a drought. We've gone through an extraordinary period of low inflation and high real gross domestic product figures.
Q: Do you have your own estimate of future inflation?
Hollyer: Ian MacKinnon, who is the head of our fixed-income group and handles a lot of the macroeconomic and interest-rate forecasting for us, is looking for 3% and perhaps a touch higher in the near term.
Q: What's the near term?
Hollyer: That's a one-year projection. If you go much beyond that, you're maybe not so much forecasting as you are guessing.
Q: An honest guy. Why hasn't Vanguard brought out this fund sooner? It's been over three years since the Treasury started issuing these kinds of bonds.
Volpert: It has a lot to do with letting the market develop and grow. It's a very small market. Right now it's about $100 billion.
Q: What are the risks in TIPS? Is there some "government risk," a change in Treasury Secretary or Administration? Could the government fiddle with the inflation adjustment?
Hollyer: We've been through a period where the Bureau of Labor Statistics has made a series of technical refinements to the consumer price index calculation. From what I understand, the lion's share of that technical adjustment process is behind them, although it's an evolutionary process...as they get new information about how inflation is measured and produced...they'll make refinements. But I would assign a relatively low risk to that sort of a situation.
Volpert: One risk is a rise in real interest rates.
Q: Explain, please.
Volpert: If the Treasury has to go from [paying] 4.10% real yield to 5% real yield, TIPS are not going to perform well.
Q: On price?
Volpert: On price, right. Another risk that could exist is that if for some reason the Treasury did decide not to issue any more TIPS, it's probably likely that they would lose some liquidity because there wouldn't be the ongoing development of that market.
Hollyer: They might experience a scarcity premium at the same time.
Volpert: Yeah, they could. It's hard to know how the market would react, but we take great comfort from the fact that when they have these huge, huge surpluses, they're still developing and maturing and growing the inflation-indexed market.
Q: For small investors, is there a reason to buy the fund as opposed to buying I Bonds?
Hollyer: The "I Bond," the Inflation-Indexed Savings Bond program, has pluses and minuses. Probably the biggest plus for individuals is that one can invest without transaction costs for very low dollar amounts. Our fund will have a $3,000 minimum initial investment and $1,000 minimum for IRA investors. So, that's one plus to the savings bonds. Once you get beyond that, the savings bond has some shortcomings if your time horizon is less than some number of years...
Q: ...five years. If you cash in inside of five years, you lose three months' interest.
Hollyer: That's a pretty hefty penalty.
Volpert: A lot of the advantages are the same as investing in bond funds in general. You have a lot more liquidity. If you meet the minimum $3,000 amount, you can write checks on these funds.... if you need $2,000 for whatever purpose, you can get it out pretty easily.
Q: Would a taxable investor want to own your fund, or because of the current taxation of future income, is it really more geared toward a tax-qualified investor?
Hollyer: When you're dealing with that "phantom income" issue that a lot of the press has focused on, the mutual-fund structure actually helps a taxable investor get around that.
Q: How's that?
Hollyer: We're required by investment-company rules to distribute virtually all of the fund's income every year. And that includes both the real coupon as well as the accretion of the bond's price due to inflation. So on a cash-flow basis, an investor in the mutual fund will achieve matching of income for investment purposes with their taxable income in the current year.
Q: What else should an investor know about the funds?
Hollyer: This fund will return income to shareholders on a quarterly basis rather than monthly.... We feel that will be slightly more stable, slightly less subject to a problem of a very short-term dip in inflation.
Q: What else?
Hollyer: Occasionally investors will ask what [happens] if there's deflation. The Treasury has made it clear that in the unlikely event [of] an absolute decline in the price level over the life of an inflation-indexed bond, they will repay the full face value at maturity.
Q: So you can't lose money if there's deflation? The Treasury is insuring a floor, in other words?
Hollyer: It's backstopping investors against an overall decline in the price level across the holding period, which would really be an unprecedented event.
Barker covers personal finance in his weekly column, The Barker Portfolio, for Business Week from Melbourne Beach, Fla. And he appears every Friday on Business Week Online
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