Jonathan Clements

Are TIPS Tops Among Bond Funds?

In her June 21, 1999 Wall Street Journal article, "Discovering Inflation-Indexed Bond Funds," Karen Damato takes a look at bond funds specializing in a recent innovation of the U.S. Treasury - inflation-indexed bonds, more commonly known as TIPS (Treasury Inflation Protected Securities). "They are probably the best-performing set of bond funds that investors have never heard of," she writes. This type of indexing obviously differs from typical equity indexing. Inflation, a macroeconomic variable that most investors fear, is the source of the returns.

A small trio of inflation-indexed bond funds have performed well this year even as rising rates have hammered most traditional bond funds. Remember that these are actively-managed bond funds that invest in indexed instruments, not passively-managed index funds. Among the three, Pimco Real Return Bond Fund has been the best performer of the last two years. Indexfunds.com spoke with John Brynjolfsson, portfolio manager and Senior VP at Pimco. His remark, "There hasn't ever been any investment vehicle that meets investors' objectives to the T," captures the uniqueness of inflation-indexed bonds. He explains why Pimco established their fund (Nasdaq symbol: PRRIX) and how TIPS compare to stocks and traditional bonds.

TIPS perfectly hedge against inflation since their par value is tied to the Consumer Price Index. Investors can lock in a real, that is, after-inflation rate of return (now just under 4% on the 10-year indexed Treasury). The interest rate is fixed in percentage terms but since the par value of the bond is tied to the CPI, the coupon payments and the final repayment of par value move one-for-one with inflation.

As inflation has declined over the course of the '90s, investors have not felt the need to hedge their portfolios against inflation. But inflation-indexed bonds still make sense as both stocks and traditional bonds, the predominant assets in investors' portfolio, suffer in inflationary periods. The yield on inflation-indexed bonds (without the inflation-adjustment) is typically compared to that of regular Treasuries with the same maturity. Right now, U.S. Treasuries yield about 2% more than their indexed counterparts. Over time, "should inflation come in at a faster-than-2% clip, you would do better.with the indexed bonds," explains David Schroeder, manager of American Century Inflation-Adjusted Treasury Fund, in Damato's article.

Indexed Treasuries can be purchased through inflation-indexed bond funds, from your regular broker, or directly through the government's Treasury Direct Program. "The tax implications make it better to own it in a fund than individually," says Mr. Brynjolfsson.

Review by Rahul Seksaria, Assistant Editor