Two Faces of a Bond That Beats Inflation
By BETH KOBLINER
type of Treasury bond intended to protect investors from inflation has prompted a turf war involving some of Wall Street's most prominent firms.
At issue is whether Treasury inflation- protected securities, commonly known as TIPS, are too good a deal for investors. Opponents say the government has been losing money on them. Defenders question that accounting, and say that because the securities offer investors an inflation-proof way to diversify their portfolios, they should be preserved.
"For the long-term investor, these are the closest thing to a risk-free asset," said William Lloyd, director of research at Barclays Capital, a leading dealer of the bonds. "With TIPS, the Treasury is attracting people who may have never bought Treasuries before, and by expanding the market in the long run they actually lower the overall cost of funding for the government."
A Treasury advisory committee recommended in May that sales of the bonds stop. The panel comprises representatives of 20 bond dealers and institutional investors, including Goldman Sachs (news/quote), Merrill Lynch (news/quote) and Salomon Smith Barney, a division of Citigroup (news/quote). "The majority of the committee has been opposed to TIPS for a number of years, but the Treasury doesn't always listen to us," said Woody Jay, managing director of Lehman Government Securities and vice chairman of the panel.
TIPS supporters met privately with Treasury officials in June. The meeting included representatives from Barclays Capital, the State of Florida, TIAA-CREF, Bridgewater Associates, the Vanguard Group and the Pacific Investment Management Company, known as Pimco.
"There was a feeling among us and some other large investors that the Treasury was only hearing the voice of the Wall Street dealers," said Dan Bernstein, director of research at Bridgewater, which manages $4.5 billion in inflation-indexed bonds. (Barclays and Pimco are members of the Treasury advisory committee. A Pimco spokesperson said the firm disagreed with the committee's recommendation; a spokesman for Barclays would not comment.)
Introduced in 1997 under Treasury Secretary Robert E. Rubin, at the urging of Lawrence H. Summers, who would be his successor in the Clinton administration, the bonds are intended to protect investors' purchasing power.
As of Wednesday, the date of the most recent auction, TIPS provided a base return of 3.5 percent for a 10-year issue maturing in January 2011. In addition, the principal is adjusted to reflect changes in the Consumer Price Index; when inflation rises, the principal rises with it. Interest is paid twice a year, based on the adjusted principal.
Traditional Treasury issues are not guaranteed to keep up with inflation. A traditional 10-year Treasury bought for $10,000 is cashed in at maturity for $10,000; it pays interest twice a year. A 10-year note maturing in February 2011 yielded 5.28 percent on Wednesday.
An important question for investors is whether inflation will rise enough to make up for the difference between the base return of TIPS and the yield on traditional Treasuries. This difference, or implied inflation rate, was 1.78 percent as of Wednesday. If inflation over the life of the bond is less than 1.78 percent, on average, then the regular Treasury bond will turn out to be a better deal. If inflation is higher than 1.78 percent, TIPS will be the better option.
(TIPS' cousins, Series I savings bonds, are also adjusted for inflation. They tend to have slightly lower rates than TIPS bonds but grow tax-deferred, and many analysts consider them even more attractive for small investors.)
Issued three times a year, TIPS can be bought directly from the Treasury in denominations starting at $1,000. On Wednesday, $5 billion of TIPS were auctioned. The next sale is scheduled for October. They can also be bought or sold, for a fee, through brokers. Another option is mutual funds, which may be more economical for smaller investments. "I like funds, especially if you're investing less than $10,000," said Lew Altfest, a money manager in New York.
TIPS have sometimes underperformed traditional Treasuries. Since early 1997, when first issued, 10-year TIPS had a cumulative return of 29.5 percent through June 2001. That compares with 36.2 percent for traditional 10-year Treasuries over that period, according to calculations by Vanguard.
But most of the gain for traditional Treasuries, occurred from February 1997 through September 1998, when inflation was falling faster than expected. Traditional Treasuries outperformed TIPS by 19.5 percentage points over that period. But from October 1998 through June 2001, TIPS had a total return of 21.3 percent, versus 7.9 percent for traditional Treasuries.
Investors seeking stability have begun to turn to TIPS mutual funds, holding bonds of varying maturities. Vanguard Inflation- Protected Securities, for example, started in June 2000, has grown to $360 million in assets. Pimco Real Return Bond has taken in $500 million in the last six months and now has more than $1.2 billion.
Chip Plumb, 44, of Evanston, Ill., transferred all of his wife's and his own I.R.A. money into the Vanguard fund in January. "The TIPS provide inflation insurance," he said. "If inflation goes up, the equities in my portfolio will get hurt, but the inflation- protected bonds would do well."
The State of Florida has 11 percent of its $1.3 billion endowment fund from its 1998 tobacco settlement invested in inflation-indexed securities. "TIPS are less volatile than traditional bonds," said Coleman Stipanovich, deputy executive director of the Florida State Board of Administration.
But opponents of the bonds say they are a bad deal for the federal government. According to the May report of the advisory committee, the government paid $1.5 billion more in coupon payments since the inception of the TIPS program than it would have with traditional bonds.
In recent years, the Treasury has cut back on bond sales, and the advisory panel contends that TIPS should be next on the chopping block. They now represent about 8 percent of Treasury notes and bonds.
Critics of the advisory committee say the extra cost of TIPS was a temporary phenomenon stemming from the collapse of the Russian debt markets in 1998, when worldwide deflation fears sharply decreased demand for inflation-protected securities. "Two auctions in a global crisis do not make a representative sample to judge a program on," a report from Barclays said.
TIPS proponents also say many dealers oppose the bonds because they are intended for the buy-and-hold investor, not for traders. "Dealers make their money from volume and TIPS don't turn over very much," Mr. Bernstein said.
Mr. Jay of Lehman disagreed: "There are dealers who are pro- TIPS and investors who are anti- TIPS."
Defenders of TIPS contend that they give the government a market barometer of inflation. "Every country I know of that has issued inflation-indexed bonds since 1950 has subsequently seen a drop in its inflation rates," said John Brynjolfsson, a portfolio manager at Pimco. "Inflation-fighting credibility is the No. 1 way for a country to minimize the cost of its debt."
The Bush administration has given no indication of its position. Tony Fratto, a Treasury spokesman, declined to comment, but the department has said that the program would continue until further notice.
Mr. Jay said: "This is a product developed by Rubin and Summers. Obviously you have new players now, and we don't know how they feel."