Wednesday, February 20, 2008

WSJ: In Times of Turmoil, Cautionary TIPS Tale

In Times of Turmoil, Cautionary TIPS Tale
Investors Flock to Bonds With Inflation Protection, Sending Prices Soaring

Wall Street Journal
Wednesday January 9, 2008 Pg C13

In times of market turmoil, many investors seek a haven for their money. And right now many are buying up inflation-protected U.s. government bonds in the belief that they are the safest investment around.

The markets are volatile amid worries about a recession, even as signs of inflation pressure emerge.

The best TIPS funds, meanwhile, offer low fees and a straightforward exposure to TIPS. Among the most popular, are Vanguard's Inflation Protected-Securities Index fund, and an exchange-traded fund, Lehman TIPS iShare.

All Crowd In?

The only problem is that everyone has the same idea. Huge demand has sent the price of these bonds, known as Treasury Inflation-Protected Securities, or TIPS, soaring to lofty levels. And while investors may not realize it, at current valuations thaey offer much more meager returns than normal.

TIPS are a relatively new class of government bond, launched in the 1990s. They offer an appealing double benefit for investors - especially those, such as retirees, seeking safety and conservation of capital.

First, like ordinary U.S. government bonds, they offer guaranteed income and return of capital. They are issued by the federal government and the risk of any default is miniscule.

Second, unlike most government bonds, they contain insurance against a rise in inflation as well. Through a complex formula involving both coupons and bond prices, TIPS guarantee that their annual interest rate will keep up with fluctuations in the consumer-price index over the price of the bond. They offer a guaranteed "real" yield on top of the CPI.

Careful on the Seesaw

Bonds work like a seesaw: When the price rises, the yield you get falls.

The accompanying chart shows that this is doing to TIP yields. The "real" or after-inflation yield on a benchmark 10-Year TIP has plunged by nearly half, from over 2.8% in August to just 1.57% today.

History is pretty clear. That tends to prove a poor deal for investors.

Only twice in recent history have these real yields fallen to similar levels: In early 2004, and again in 2005. On both occasions, those who invested quickly lost money as the bonds fell back again and the yields rose.

The best time to buy TIPS is when they are out of fashion and the real yield being offered is over 2%. The market seems to consider that a good long-term value.

TIPS do offer guaranteed income and protection against inflation. But always on Wall Street, price matters too. And there is no safety in numbers.

If TIPS appear to offer meager pickings right now, the same could also be said for regular government bonds - the ones with no inflation protection. The current yield on the 10-year Treasury is a dismal 3.85%, and 4.36% on the 30 year. Both have collapsed since last summer. It is worth adding that these yields are all subject to federal income tax as well, unless the bonds are held in a tax-sheltered account like an IRA.

For savers seeking better interest, it may be sensible to wait in cash for better opportunities. E*Trade Financial Corp.'s E*Trade Bank, for example, offers a savings account paying 4.93%. And deposits are federally guaranteed up to $100,000.

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