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TIPS at the top

Inflation-protected Treasuries have delivered an impressive performance. In light of recent economic data, many investors expect that their winning streak will continue.

U.S. Treasury inflation-protected securities have enjoyed a major growth spurt in their first seven years: The volume of outstanding TIPS shot up from about $30 billion at the end of 1997 to $224 billion in April of this year, and daily trading of TIPS climbed from $800 million to $4.6 billion.

This rise is understandable. Since they were created in 1997, TIPS have offered better returns with less volatility than their fixed-rate brethren. In fact, investors have begun to view them as a distinct asset class that is likely to grow more important as soaring oil prices, strong employment growth and rising consumer prices stoke inflation fears.

Between 1997 and the end of February 2004, ten-year TIPS on average outperformed fixed-income Treasuries by 30 basis points a year, beat the Lehman Brothers U.S. aggregate bond index by 80 basis points and exceeded the Standard & Poor's 500 index by 140 basis points. In a few months the U.S. Treasury Department will offer two new versions of TIPS: a five-year bond and a 20-year bond.

Last year U.S. TIPS posted total returns of 8.4 percent, compared with 2.2 percent for U.S. Treasuries and 28.7 percent for the S&P 500.

The yield on a Treasury inflation-protected security is fixed at auction and paid semiannually. The inflation-adjusted component of the bond, which varies with each maturity, is factored monthly into the principal price by continuously multiplying the bond's value at issuance by an inflation index ratio. This inflation adjustment accrues over the life of the bond and is paid at maturity, but it's reflected in the bond's market value.

For a given maturity, the difference in yield between TIPS and nominal Treasuries reflects investor expectations of future inflation. Economists refer to this difference as the break-even inflation rate. When the break-even gap widens to, say, 300 basis points, investors are betting that inflation will average at least 3 percent over the life of a bond of comparable maturity. Nominals will outperform if inflation averages less than 3 percent or if the Fed pushes up interest rates well ahead of inflation and subsequently restrains consumer price growth.

Significantly, ten-year TIPS have delivered above-average returns with less volatility than Treasuries. Barclays Capital calculates the annual standard deviation of TIPS to be 5.4 percent. That's 3.1 percentage points less than that of nominal Treasuries and 0.30 percentage points less than that of the Lehman bond index.

In tailoring portfolios for investors, John Brynjolfsson, portfolio manager of Pimco's Real Return Bond Fund, the largest TIPS fund, works with clients to create a customized benchmark and establish risk parameters.

Many inflation-protected funds may invest up to 20 percent of assets in non-U.S. TIPS -- foreign Treasuries, corporates, high yields and derivative products -- and managers use this freedom in different ways. Pimco, for example, places between 10 and 15 percent of its TIPS exposure in interest rate derivatives that are uncorrelated with TIPS. "Doing so," explains Brynjolfsson, "hedges out the bond exposure inherent within TIPS through the use of interest rate swaps, which provides an upside if interest rates go up."

Varun Mehta, portfolio manager of Mason Street Advisors' $153 million Select Bond Fund, recommends laddering a portfolio of various maturities to gain an appropriate balance across the yield curve.

Not surprisingly, investors can now choose among a dozen inflation-protected bond funds. Pimco's Real Return Bond Fund has $11 billion in assets, up from $5 million in January 1997.

In March 2003, when inflation was more quiescent, the yields of ten-year Treasuries were 181 basis points higher than the yields of comparably maturing TIPS. A year later the gap had widened to 240 basis points. During the first three weeks of April, with employment picking up and the March consumer price index coming in stronger than expected, the spread hit 254 basis points.

According to Bridgewater Associates, a money manager that keeps 12 percent of its $65 billion in assets in TIPS, ten-year issues were negatively correlated with fixed-rate Treasuries and the S&P 500 over three- and five-year intervals. "By going back to 1970 and synthetically re-creating TIPS by identifying real yields and how CPI would affect principal, we found that TIPS provide asset diversification, protection of purchasing power and less volatility than nominal Treasuries," explains Bridgewater research director Daniel Bernstein. "These benefits have led some of our institutional clients to place up to 30 percent of their fixed-income portfolios into inflation-protected products."

Although investors are drawn to TIPS as a hedge against inflation, Pimco's Brynjolfsson argues that the recent bear market heightened attention to risk analysis and a more analytical approach to asset allocation. "Within this context," he says, "TIPS appeal because they lock in purchasing power over a given period of time, helping to match assets with future financial liabilities."

Certainly, there's a case to be made that inflation is on the rise. The dollar remains weak, oil and gasoline prices are reaching record levels, and commodity prices have been rising steadily.

But Mason Street's Mehta believes that the recent spike in inflation won't last, because companies don't enjoy much pricing power. He recently pared back his position from a peak of 12 percent of fund assets in October 2002 to 3 percent. "I just don't believe that relative returns of TIPS will continue to outperform nominal Treasuries," says Mehta, who has replaced his TIPS with fixed-rate bonds.

On the other hand, Steven Traum, who manages TIAA-CREF's $374 million Inflation-Linked Bond Fund, thinks TIPS still look attractive. Though he could place up to 20 percent of his portfolio in non-inflation-protected securities, he remains fully invested in TIPS. "I believe that they'll continue to appreciate, given current supply-and-demand trends," Traum says. Foreign central banks, endowments and pension funds will seek more protection against inflation, he asserts, pushing up the value of TIPS.

Inflation-protected government securities are not confined to the U.S. They are also issued by ten countries -- Australia, Canada, France, Greece, Italy, Japan, New Zealand, South Africa, Sweden and the U.K. According to Barclays Capital, returns on foreign inflation-protected securities have significantly outpaced U.S. TIPS, owing to the weakening dollar and generally higher interest rates abroad. Through April 19, Australian, Canadian, French, South African and Swedish securities generated about double the returns of U.S. TIPS in dollar terms over the past three years (see table).

Says Mark MacQueen, who co-manages $3.2 billion at Sage Advisory Services in Austin, Texas, "Just as with equities and any other asset class, proper global asset allocation reduces volatility and enhances returns." Still, he adds, "many investors opt against foreign exposure to ensure that assets are in the same currency as future liabilities."

Though the U.K. TIPS market is substantial, with total assets of $159 billion, liquidity in most other foreign TIPS markets is much more limited. According to Barclays Capital, the Australian market totals just $7.2 billion, the Canadian market is $20.6 billion, and the Japanese market is less than $1 billion. Investors must hunt a bit when venturing abroad.

Annualized performance of inflation-linked foreign sovereigns

One-year Three-year Five-year No. of Value

return* return return Issues ($ billions)
Australia 26.46% 20.36% 10.52% 4 $7.20
Canada 24.52 18.23 13.99 4 20.55
France** 19.15 20.79 8.99 6 75.49
France 18.6 21.08 9.15 3 43.63
France (euro) 20 N/A N/A 3 31.85
Italy .N/A .N/A .N/A 2 19.22
Japan .N/A .N/A .N/A 1 0.9
South Africa 21.97 26.22 .N/A 4 4.3
Sweden 17.87 20.02 9.61 5 26.11
U.K. 21.27 15.13 6.67 10 159.08
U.S. 8.93 10.15 9.94 12 223.97
Total$612.30
* All returns are calculated in dollars as of April 19, 2004.
** France has three series of inflation-protected government bonds. Two track French consumer price growth; one tracks euro-zone consumer price growth.
Source: Barclays Capital.