TIPS for Beating Inflation

The role that treasury inflation-protected securities (TIPS) play in a diversified bond portfolio got a big boost in 2007. As many investors labored to eke out gains amid crumbling credit markets, the stars aligned for inflation-indexed bonds, and the Lehman Brothers TIPS index returned an impressive 11.7%.

Three developments drove returns. First, TIPS benefited from a flight to quality. Second, a slowing economy and interest-rate cuts by the Federal Reserve boosted results. Finally, inflation (and expectations of further inflation) rose. TIPS are indexed to the consumer price index, which surged from 2% at the start of 2007 to 4% by year's end, mainly because of rising oil and food prices.

If you buy a conventional Treasury, you receive the same interest payment semiannually for the life of the bond. With TIPS, the Treasury adjusts the principal value of a bond each month (with a two-month lag time) to keep pace with inflation. A higher principal value also lifts interest payments.

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When pros compare Treasuries and TIPS, they study the break-even inflation rate. In mid January, ten-year Treasuries yielded 3.8%, and ten-year TIPS yielded 1.6%. That implies a break-even inflation rate of 2.2 percentage points. If inflation over the next ten years tops 2.2% annually, you'll do better with TIPS than with the equivalent Treasuries.

Just the prospect of accelerating inflation argues for a place for TIPS in the portfolios of retirees who are concerned about maintaining the purchasing power of their savings. TIPS perform well even in periods of rising inflation coupled with stagnant economic growth (known as stagflation), a knotty environment for investors.

Fund managers such as Dan Shackelford, of T. Rowe Price Inflation Protected Bond, think strong demand from emerging markets will continue to push food and other commodity prices upward over the long haul. "A 2.2% break-even looks like an easy bogey to beat over ten years," he says. Shackelford looks for TIPS to return 5% to 6% in 2008. Last year, his fund (symbol PRIPX; 800-638-5660) returned 11.1%. Over the past five, it gained 5.5% annualized, compared with 5.2% for the average TIPS fund.

The granddaddy of TIPS funds is Pimco Real Return Institutional. John Brynjolfsson ran the fund from its inception in 1997 (the first year Uncle Sam began issuing TIPS) until he turned over the lead-manager role to Mihir Worah in December. The fund's minimum investment is out of sight, but with just $1,000 you can buy a virtual copy, the two-year-old, Pimco-managed Harbor Real Return Institutional fund (HARRX; 800-422-1050), which gained 11.4% last year. Pimco's team invests some assets in foreign inflation-indexed bonds.

Another fine choice is Vanguard Inflation Protected Securities (VIPSX; 800-635-1511), managed by John Hollyer and Kenneth Volpert since its launch in June 2000. It's tamer than the Harbor fund and has rock-bottom expenses (0.20% per year); it returned 11.6% in 2007 and 6.1% annualized over the past five years.

How much to allocate to TIPS? Volpert suggests that retirees split Treasury holdings between conventional bonds and TIPS. Brynjolfsson says Pimco advises splitting a diversified portfolio into three categories: stocks, bonds and such assets as TIPS, commodities and real estate that help offset rising prices. "Bonds protect against deflation," he says. "TIPS protect against inflation."