In her June 21, 1999 Wall
Street Journal article, "Discovering Inflation-Indexed
Bond Funds," Karen Damato takes a look at bond funds specializing
in a recent innovation of the U.S. Treasury - inflation-indexed
bonds, more commonly known as TIPS (Treasury Inflation Protected
Securities). "They are probably the best-performing set of bond
funds that investors have never heard of," she writes. This type
of indexing obviously differs from typical equity indexing. Inflation,
a macroeconomic variable that most investors fear, is the source
of the returns.
A small trio of inflation-indexed bond funds have performed well
this year even as rising rates have hammered most traditional
bond funds. Remember that these are actively-managed bond funds
that invest in indexed instruments, not passively-managed index
funds. Among the three, Pimco
Real Return Bond Fund has been the best performer of the last
two years. Indexfunds.com spoke with John Brynjolfsson, portfolio
manager and Senior VP at Pimco. His remark, "There hasn't ever
been any investment vehicle that meets investors' objectives to
the T," captures the uniqueness of inflation-indexed bonds. He
explains why Pimco established their fund (Nasdaq symbol: PRRIX)
and how TIPS compare to stocks and traditional bonds.
"The Treasury made it clear that they would issue a substantial
amount of these bonds and it was certain that there would be ample
supply to establish them as an investment class. Over the past
200 years, a risk-free real return of 3.9% is unheard of. Equities
have had a higher real return of around 8% over the long-term.
But over 5 year periods, stock returns have been as low as minus
11% a year to as high as positive 26% a year, writes Jeremy Siegel
in his book, "Stocks for the Long Run." If you can risk losing
half your money then the 8% is worth taking advantage of . . .
In comparison to traditional bonds with similar maturity, TIPS
exhibit much lower volatility on a real basis and have comparable
returns."
TIPS perfectly hedge against inflation since their par value
is tied to the Consumer Price Index. Investors can lock in a real,
that is, after-inflation rate of return (now just under 4% on
the 10-year indexed Treasury). The interest rate is fixed in percentage
terms but since the par value of the bond is tied to the CPI,
the coupon payments and the final repayment of par value move
one-for-one with inflation.
As inflation has declined over the course of the '90s, investors
have not felt the need to hedge their portfolios against inflation.
But inflation-indexed bonds still make sense as both stocks and
traditional bonds, the predominant assets in investors' portfolio,
suffer in inflationary periods. The yield on inflation-indexed
bonds (without the inflation-adjustment) is typically compared
to that of regular Treasuries with the same maturity. Right now,
U.S. Treasuries yield about 2% more than their indexed counterparts.
Over time, "should inflation come in at a faster-than-2% clip,
you would do better.with the indexed bonds," explains David Schroeder,
manager of American
Century Inflation-Adjusted Treasury Fund, in Damato's article.
Indexed Treasuries can be purchased through inflation-indexed
bond funds, from your regular broker, or directly through the
government's Treasury
Direct Program. "The tax implications make it better to own
it in a fund than individually," says Mr. Brynjolfsson.
Review by Rahul Seksaria, Assistant Editor
