The Wall Street Journal

May 5, 2005

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Wall Street Pushes Inflation Protection

Securities Keyed to Consumer
Prices Gain Favor, But Returns,
High Markups Are Issues

May 5, 2005; Page D1

Investors are increasingly concerned about inflation, and Wall Street is happy to oblige them.

Securities firms including Merrill Lynch & Co. and Bear Stearns Cos. are aggressively pitching inflation-linked products, ranging from municipal and corporate bonds to certificates of deposit, all of which aim to provide investors with a return above the rate of inflation. At the same time, Treasury Inflation-Protected Securities, or TIPS -- Treasury bonds whose value increases with inflation -- are seeing renewed interest.

The push comes as the Federal Reserve raised its short-term target interest rate for the eighth time in a year this week, to 3%. In a statement, the Fed said "pressures on inflation have picked up in recent months and pricing power is more evident."

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Last week, Connecticut closed a deal on $55 million of inflation-indexed municipal bonds, following the lead of such issuers as New York City, Massachusetts and the District of Columbia, which issued their own inflation-linked securities during the past six months. For the 12 months ended in April, the Treasury sold nearly twice as many TIPS as in the previous 12-month period, bringing the size of the TIPS market to about $286 billion. SLM Corp., also known as Sallie Mae, issued $100 million of inflation-linked bonds in March and then, spurred by additional demand, issued another $100 million in April.

There is big caveat for investors: Costs tend to be higher for inflation-linked products. Small investors often pay bigger markups on these bonds than do their institutional counterparts. For example, an investor buying $50,000 of these issues might pay as much as $500 more than does a money manager. The fee is built into the face value of the note. Commissions aside, TIPS have become more expensive in recent months, meaning that $1,000 will buy you a lower yield now than it did last fall, while corporate and municipal inflation-linked securities also are pricey.

Furthermore, if inflation eases, investors could get burned by these products, which typically pay less than comparable fixed-rate investments. Assuming no inflation, for example, the current 10-year TIPS would only pay out a yield of about 1.6%, while the regular 10-year Treasury note pays about 4.2%. Some evidence that inflation may not be the most serious long-term threat: Yields on long bonds have been falling recently, which could indicate that investors see slower economic growth as the biggest threat to investors.

Another major concern: The index that nearly all of these products are tied to -- the consumer-price index's urban reading -- may not accurately reflect rising consumer prices. "The CPI is an arbitrary and deficient measure of inflation," says James Grant, editor of Grant's Interest Rate Observer. Among other things, he says, it understates the rise in residential real-estate prices.

Amid growing concerns over inflation, Wall Street is marketing products whose principal and income payments are designed to keep pace with rising prices. See some of the most popular inflation-linked securities2.

The financial-services industry is pushing inflation-linked products to small investors worried about the prospect of their assets eroding.

Corporate bonds that pay out monthly income that moves in line with the consumer-price index.

Municipal bonds that pay out semiannual income that moves in line with inflation; interest income is free from federal taxes.

The risk: These products are expensive, and investors may lose out if inflation eases.

Because of the associated costs and other issues, many experts say that only a small portion of one's portfolio -- typically 5% to 10% -- should be parked in inflation-linked products. Still, for individuals heavily invested in stocks, which could take a hit during a period of steep inflation -- or for retirees who want to make sure their savings keep pace with inflation -- some inflation-protected investments are worth considering. High-income investors might benefit from buying some of the muni bonds for their taxable accounts.

Here is how the most popular of these products work -- and the risks they pose for investors:

Treasury Inflation-Protected Securities (TIPS)

TIPS are bonds issued by the Treasury Department. What makes them popular in this environment is that their underlying value is tied to the rate of inflation. When TIPS mature, investors receive back the original value of the bond, plus an additional sum to account for inflation. If inflation eases, the investor is assured of getting back the original principal, which is backed by the U.S. government.

This inflation protection does come at a cost. Most notably, the interest rate on TIPS is substantially lower than on standard Treasurys. Investors have thrown so much money at this market in recent months that they have bid up the prices, which move inversely to yields. As a result, the difference in yields between conventional 10-year Treasury notes and 10-year TIPS is now about 2.6 percentage points, which represents what the market expects the annual rate of inflation will be over the next decade. If inflation fails to reach that level, Treasury notes may prove to be a better investment than TIPS.

One big knock against TIPS is that investors owe "phantom taxes" each year on the increased value of the principal, even though that money isn't received until the bond is sold or matures. That is why TIPS often are better for tax-deferred accounts.

Investors can save on trading costs and markups by buying TIPS directly at Investors do have to wait until the Treasury holds an auction, which it does at regular intervals throughout the year, at which they can buy newly issued TIPS in $1,000 increments.

Municipal and Corporate Inflation-Linked Securities

States and other municipalities are issuing more inflation-linked municipal bonds. Unlike conventional munis, these securities feature interest payments that increase in value as inflation heats up. Otherwise, they have the same tax advantages as do standard municipal bonds. Experts estimate the size of this market -- which has ramped up in the past two years -- at just less than $1 billion.

The number of companies issuing inflation-linked bonds today has doubled to six to eight offerings each week from a year ago, says Rob Little, managing director in Merrill Lynch's debt capital markets group. They can be purchased in small denominations of $1,000 through "retail notes programs" such as those run by Incapital LLC, Merrill Lynch and LaSalle Broker Dealer Services Division, a unit of ABN Amro Holding NV.

For both these muni and corporate securities, coupon payments are linked to year-to-year changes in the consumer-price index plus a fixed rate. Corporates generally pay out interest every month, while munis pay out twice a year.

One big difference between these securities and TIPS is that changes in the inflation rate are immediately reflected in their coupon payments, so investors get more of the inflation adjustment up front.

Because of the way in which these deals are structured -- which involves a less mature derivatives swaps market -- the yields on these products probably are about 0.4% lower than they should be, says Michael Ashton, managing partner at Ashton Analytics LLC, a hedge-fund manager in Morristown, N.J. "Most of the issuances have been very expensive debt to buy," he says. "It's not something I'd recommend to average retail investors." What is more, since the market for corporate and municipal inflation-linked bonds is relatively small, individual investors may find it difficult to buy and sell appropriately priced bonds.

Inflation-Linked Certificates of Deposit

The monthly payouts of inflation-linked CDs, which are sold by LaSalle Broker Dealer Services through brokers, also are linked to year-over-year changes in the consumer-price index. Like bank-sold CDs, they are insured by the Federal Deposit Insurance Corp. up to $100,000. Investors get a lower initial yield compared with traditional CDs or regular Treasurys: A new 5½-year CD, for example, pays out only 1%, according to the company, compared with the average 3.78% rate being offered on conventional five-year CDs, according to But with the current inflation adjustment, the CD's first coupon, payable on June 10, pays 4.15%.

The company says it has sold more than $1 billion of these CDs since the product's launch in February 2004, mostly in five- to seven-year maturities. Minimum investments are $1,000. Like inflation-linked corporate bonds, sales commissions are built into the face value of the CD.

Write to Jane J. Kim at

[Inflation Fighters]

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