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Experts Seeing Growing Role for Inflation-Linked TIPS

Inflation may appear to be tamed-the core Consumer Price Index (CPI) rose just 0.1 percent in September-but US government bonds that offer a built-in hedge against rising prices are gaining in popularity nonetheless and attracting dollars from some private and public pension funds. For Peng Chen, Director of Research for the investment consulting firm Ibbotson Associates, that makes sense. He says the securities-U.S. Treasury Inflation Protection Securities, or TIPS-are attractively priced right now and offer investors not just a hedge on inflation but also important portfolio diversification benefits.

TIPS were first issued by the U.S. government in 1997. Unlike conventional Treasuries, they offer coupon payments that are fixed in real rather than nominal terms, with nominal interest payments adjusted according to the actual inflation rate as measured by the CPI. Furthermore, at maturity, the holder of TIPS received the greater of the original principal amount and the inflation adjusted principal amount.

Early TIPS issues struggled for an audience, in part because they were new and in part because the stock market was posting 20-percent-plus annual gains at the time, distracting many investors from fixed-income investments. Meanwhile, ordinary Treasury issues were generating nice returns of their own in 1997; those with maturities of ten years or more would earn a little more than 14 percent that year, and also deflected attention from the new securities.

TIPS have enjoyed growing acceptance since their inception, as the stock and bond markets have experienced substantial volatility, and as TIPS have built a track record that institutional investors can reference when making allocations to the securities. From March 1997 through August 2003, says Gemma Wright, a Market Strategist with Barclays Capital, TIPS earned about 7.5 percent, and they now account for 25 percent of the federal government's ten-year note issuance.

Wright observed that TIPS are currently trading at a price that assumes a 2.1 percent inflation rate over the next ten years. That is, if inflation were to average 2.1 percent, returns on TIPS over that period would equal those on ordinary Treasuries of comparable maturity. If inflation were to be higher, TIPS would outperform Treasuries, and if inflation were to be lower, TIPS would underperform. Given surveys indicating that economists anticipate an inflation rate of 2.5 percent to 2.6 percent over the next ten years, Wright says, TIPS would appear to be underpriced, at least by that measure.

Whatever the near-term outlook for TIPS, both Wright and Chen stressed that because TIPS have a low correlation to traditional bonds, including TIPS in a diversified investment portfolio can help investors build a portfolio farther out along the efficient frontier, potentially enjoying higher returns with no added risk, or less risk with no sacrifice of return.

Chris Tobe, a Director with the Pensions and Savings Group at AEGON Institutional Markets added that for all the reasons cited above, TIPS are enjoying a growing acceptance among investors and money managers. With increased liquidity in the TIPS market, he added, it is not surprising that AEGON and other firms have also begun to develop other inflation-indexing and enhanced indexing strategies to serve as a complement, or alternative, to a straightforward TIPS investment strategy.

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