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Stock tips in this market? How about bond
TIPS?
Heydon Traub, Boston Business
Journal, March 15, 2002
Two years ago, following the longest bull market ever, one had to look far
and wide to find someone interested in investing in bonds or bond funds.
Well, the last two years might make a good movie title: "Revenge of the
Bonds."
Although a lot more people are investing in bonds lately, it is still the
case that people prefer to talk about stocks. Friends and family are always
looking for a good stock tip, no matter how poor the stock market returns
have been.
I can barely remember the last time someone came up to me and said, "Hey,
any good bond tips?"
So it is with trepidation that I move forward and write about bonds. But
this isn't about "exciting" corporate bonds, where occasionally you might
get some good stories. No, I am going to discuss boring old treasury bonds,
the kind issued by the U.S. government. But before you turn the page or fall
asleep, I will note that this isn't about your run-of-the-mill treasury
bonds. Today, we will cover TIPS, as in Treasury Inflation Protected
Securities.
I know what you are saying: Inflation is dead, so what could be more boring
than discussing treasury bonds and inflation? Well, think about this: If
something seems profoundly uninteresting, you often want to buy it. If
everyone is talking about a type of investment, steer clear.
We only have to go back to the end of 1999 to see my point. At that time,
the Internet and high-tech mania was at its peak -- and that's all anyone
talked about. Well, you would have had to live in a cave the past few years
not to know that the tech bubble has burst and investors lost their shirts
on those stocks. What was the best asset class in 2000? You guessed it: TIPS
rose about 13 percent.
Before we make the current case for TIPS, here is a quick primer on these
bonds. The government began to issue these bonds in 1996 as a way for
investors to buy bonds without the usual risk of losing money when inflation
increased more than expected.
With TIPS, the bond's principal value is increased each year by the amount
of inflation (based on the consumer price index, or CPI). So, if you put
$100,000 into a bond that matured in five years and if inflation was 20
percent over that time, you would receive $120,000 at maturity. In addition,
during that time you would get some payments reflecting the bond's yield, or
coupon payments.
The case for TIPS currently is that investors are betting that inflation
stays very low. Looking at the traditional 10-year government bond and the
inflation-protected equivalent bond, the yields are 5.3 percent and 3.4
percent, respectively. This implies that investors expect inflation to be
around 1.9 percent over the next 10 years, in which case the return on the
two bonds would be the same.
However, it seems more realistic that the bonds with the inflation
protection should provide a lower return over time since an owner of that
bond faces no inflation risk -- while the owner of the "normal" bond does.
Some might argue that investors expect about a 10-year inflation rate of 1.5
percent. With the exception of the Depression in the 1930s, the only time
inflation was that low in the past 70 years came in the 10-year periods
ending in the early 1960s.
Some may look at what's happened since TIPS were issued in 1997 and conclude
that they are not less risky in terms of volatility.
However, this period has been a low and declining inflation-rate
environment, well-suited to traditional bonds. If we were to see a rising
inflation and interest rate environment, we would argue that TIPS should
turn out to be less volatile.
One other favorable event coming up is the retirement of one of the issues
that mature in July. As these bonds are paid off, managers of TIPS funds
will have to reinvest the proceeds into the remaining TIPS bonds, pushing
those prices higher.
Now let's cover a couple of practical issues. TIPS are taxed both on the
coupon and on the value of the increasing principal level to avoid investors
using these as a way to defer taxes.
However, that means you will pay tax without receiving cash income. For
those who buy through a mutual fund and reinvest income and gains anyway,
this is not a problem. However, for those who would receive the interest
payments in cash, this might be a negative. For this reason, a retirement
plan such as an IRA or 401(k) plan might be better.
One positive on the tax front is that they are not taxed by the states (nor
is a traditional U.S. government bond), since states don't tax income from
bonds issued by the federal government.
One other practical issue is that people tend to buy and hold these, making
them less liquid and more costly to trade. So unless you are fairly certain
you will buy and hold these to maturity, you may be better off in a mutual
fund investing in TIPS. The lowest cost fund is offered by Vanguard.
Will you get rich buying TIPS? No. But to get some protection from
inflation, especially as a complement to other bond investments, TIPS fit
the bill.
In addition, given the low-risk nature of these bonds, they make a
reasonable alternative to low-yielding money market funds for those willing
to edge out just a bit on the risk spectrum. Returns should be higher, with
only modest additional risk. So there you have it -- bond TIPS for a change.
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