January 19, 2005
Popular Inflation Bonds
Investors Look Overseas
To Counter Weak Dollar
And Risk of Higher Prices
By JEFF D. OPDYKE
With the dollar in a four-year slide and commodity prices on the rise, investors are turning to foreign bonds that provide inflation protection.
These bonds act much like the Treasury inflation-protected securities, or TIPS, that U.S. investors have been snapping up since 1997. Like TIPS, they are aimed at helping investors preserve the purchasing power of their money over time. But the foreign variety has the added benefit of generating higher returns if the dollar continues to fall.
Now, an increasing number of countries are joining the mix by offering their own version of inflation-protection bonds. Germany and Korea are expected to issue such bonds later this year, and some bond pros expect Switzerland and Spain soon will join in. Japan and Italy both joined the group recently.
In all, there are about three dozen countries issuing inflation-protection bonds.
For U.S. investors, owning these overseas inflation bonds is a strategy to protect against a weakening dollar, which is being spurred along by fears of the large budget and trade deficits. The inflation bonds are also a way to guard against potential global inflation, which could be sparked by rising commodity prices around the world. What's more, foreign inflation bonds provide added diversification to a portfolio -- in this case, diversification across more than one measure of inflation.
Inflation bonds provide a so-called real return -- or a return above the rate of inflation. To do so, some measure of inflation is applied to the bond's underlying principal. Thus, as inflation rises, so too does the value of the principal. As a result, the interest payments rise slightly as well amid inflation, because the fixed interest rate is applied to the higher principal balance each period.
The key difference between U.S. TIPS and their overseas counterparts is that the foreign bonds are tied to inflation in local markets, or, in the case of some French bonds, euro inflation.
Anton Pil, global head of fixed income for J.P. Morgan Chase & Co.'s J.P. Morgan Private Bank, says the bank over the past 18 months has been focusing more on putting clients into inflation-linked investments.
"We own these as insurance against a 1970s-style inflationary environment," Mr. Pil says. He says that at least 5% of a portfolio's fixed-income component should be earmarked for inflation-linked investments. That could include not just TIPS, but inflation-linked certificates of deposit, corporate bonds and even a handful of municipal bonds.
Investors can get some protection against a falling dollar or commodity-induced inflation by owning the shares of foreign-based companies and those that benefit from rising commodity prices. Either route, however, exposes you to company-specific risk that could send a stock's share price tumbling even while a strong commodity trend or weak dollar trend continues.
Foreign inflation bonds are a safer alternative. These bonds tend to be backed by governments such as the United Kingdom, France, Canada and Sweden. As such, they are sovereign debt, not riskier corporate securities. That means, of course, you shouldn't expect stock-market-like returns. Although, if the dollar continues to drop, the pounds, euros or Swedish krona you repatriate will buy more dollars.
While going overseas to buy inflation-protection bonds provides a hedge against the falling dollar, the bonds also expose a portfolio to added risks. The most notable risk is if the dollar turns around. If that happens, assets priced in foreign currencies could lose value in dollar terms, even if their price in the local market doesn't fall.
In the U.S., the inflation measure of choice is the consumer price index-urban reading, or CPI-U, which measures price changes for urban consumers. As the CPI-U increases, the principal value of the inflation bond increases as well.
Economists as a group expect inflation in the U.S. will run between 2% and 2.5% for the next couple of years. Historically, inflation in the U.S. has run at about 3% annually.
The latest reading has the CPI-U up 3.5% in the 12 months ended in November. Minutes from the December meeting of the Federal Open Market Committee, the arbiters of U.S. interest-rate policy, hint that some members of the Fed are growing more concerned about domestic inflation rising at a quicker-than-expected pace. TIPS would serve investors well in that case because the value of the securities would rise alongside escalating inflation figures.
Overseas, the inflation measures track local economies. Some bonds issued in France, for instance, track the broader European economy. Annual inflation for the countries in the so-called euro zone ran about 2.2% in November. Countries such as Poland have seen inflation in the 4.5% range recently, while Greece's inflation rate has been at about 3.2%.
A 10-year U.S. TIPS maturing in 2015 yields about 1.7%, similar to a U.K. inflation bond maturing in 2016. Ten-year French inflation bonds yielded 1.37% recently. The Treasury auctioned off last week $10 billion of 10-year TIPS. The next auction of 20-year TIPS is slated for Tuesday.
The bonds you buy will carry whatever interest rate the auction process establishes; you won't pay trading costs or commissions. To buy TIPS, investors can purchase them online directly from the Treasury, or buy them from a brokerage firm. The Treasury sells only newly issued TIPS in $1,000 increments during regular auctions throughout the year. Investors must open an account at www.treasurydirect.gov1 to participate. Investors can buy new and previously issued TIPS through brokers, though you may pay trading costs.
Don't go looking for a foreign inflation-bond mutual fund in the U.S. Domestic mutual funds, such as the Pimco Real Return Fund, focus mainly on owning TIPS. You won't find any that concentrate on global inflation-linked bonds, according to Morningstar Inc., a Chicago investment-research firm.
Some international bond funds in the U.S. do own foreign inflation bonds, but those bonds constitute just trace amounts of the overall portfolio. That means investors who want foreign inflation bonds in their own portfolios will have to own them directly.
Where to Buy the Bonds
To buy foreign inflation bonds, clients of big brokerage houses such as Morgan Stanley and others can typically buy through their broker. J.P. Morgan's Mr. Pil says the bank's clients can "buy them in just about every market -- from Brazil to the U.K. to Japan."
Do-it-yourself investors have more-limited options because firms such as Fidelity Investments won't go overseas to buy these bonds for customers.
TD Waterhouse, a unit of Canada's Toronto-Dominion Bank, will buy foreign inflation bonds for its clients, though only in four markets: Canada, the U.K., Australia and New Zealand. TD Waterhouse requires a $25,000 minimum investment.
Charles Schwab Corp. will buy overseas inflation bonds through its global trading desk, but only in sizes of $100,000 or more and only in larger markets. Commissions also tend to be higher.
Write to Jeff D. Opdyke at firstname.lastname@example.org
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