The Inflation-Wary



The Inflation-Wary

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Treasury to Expand Offering of Bonds Indexed

To Rising Prices, as Investors Flock to Them

By JEFF D. OPDYKE and REBECCA CHRISTIE

Staff Reporters of THE WALL STREET JOURNAL

May 6, 2004; Page D1

The U.S. Treasury is making it easier to safeguard your money against the threat of inflation.

The department announced that it will expand its offering of Treasury Inflation-Protected Securities, the popular investments designed to ensure that inflation doesn't eat into an investor's returns. The Treasury already offers inflation-protected notes that mature in 10 years. In coming months, the department will add two new options: a five-year bond and a 20-year bond. These TIPS, as they are known, will be auctioned at regular intervals starting later this year.

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|MORE ON TIPS | |

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|Read more about investing in TIPS, and see a list of | |

|the largest TIPS funds on the market. | |

|• Finding the Fair Value for Tips | |

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The Treasury's move comes as investor interest in TIPS is rising. With the economy heating up -- and with it, fears of resurgent inflation -- more investors are either buying TIPS-centric mutual funds or purchasing the securities directly from the government. During the first quarter alone, investors poured about $5 billion into TIPS mutual funds, according to AMG Data Services in Arcata, Calif., up from $1.4 billion a year ago.

Wall Street is seizing the trend. Mutual-fund companies have launched four new TIPS funds during the past six months to take advantage of growing demand. At the same time, some brokerage firms are encouraging their clients to stick more money into TIPS, which, like conventional Treasury bonds, are exempt from state and local income taxes. On Monday, for example, Morgan Stanley increased its recommended allocation of TIPS by one percentage point, to 4% for moderate and aggressive investors.

TIPS represent the only asset class that "explicitly protects against inflation," says John Hollyer, the co-portfolio manager for the Vanguard Inflation-Protected Securities Fund, one of the biggest TIPS funds. Like all Treasurys, TIPS are issued by the government -- meaning their principal is guaranteed. But while an investor receives fixed interest payments over the life of the bond, the principal can rise over time, depending on what happens with inflation.

When the TIPS mature, investors receive their original principal plus an additional sum to account for inflation. (In a period of deflation, the investor is assured of getting back the original principal.)

But this reduction in inflation risk comes at a cost. For one thing, the interest rate on TIPS is lower than on standard Treasurys. And investors have thrown so much cash at them during the past year that they've bid up the prices for TIPS. As a result, the spread between conventional 10-year Treasury bonds and 10-year TIPS is now about 2.5 percentage points, representing the expected rate of inflation over the next decade.

If inflation rises more than that, TIPS will be a big winner. If it doesn't, conventional 10-year Treasurys may make more sense.

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|TIPPING POINTS | |

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|Some pros and cons of Treasury Inflation-Protected Securities, or TIPS: | |

|• They provide a real rate of return over inflation. | |

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|• Their income isn't taxable at the state and local level. | |

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|• Their principal is guaranteed by the U.S. government. | |

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|• Investors must pay tax each year on the bond's implied income. | |

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|• Their prices have risen sharply, making them a riskier investment. | |

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Taxes are another consideration. TIPS investors are taxed each year on the implied income from the inflation adjustment, even though that income isn't paid until maturity. That's why David Darst, chief investment strategist for Morgan Stanley's Individual Investor Group, advises investors to hold TIPS in tax-advantaged accounts, such as an IRA or 401(k).

Investors can also buy TIPS directly from the government at ., although these aren't tax-advantaged accounts. After opening an account through the Treasury Department, you can bid on TIPS online, by phone or through the mail during auctions every January, April, July and October. The minimum investment is $1,000.

Most small investors bid noncompetitively, meaning they order securities from the Treasury in advance of the auction and agree to pay the price established by competitive bidders. The first auction of 20-year TIPS will take place in July, while the first five-year auction will occur in October.

During the past year, TIPS mutual funds tracked by investment-research firm Morningstar Inc. are up about 5.3%. High-quality bond funds as a group are up about 1.5% in that period. Such a difference helps explain why the assets in Fidelity's Inflation-Protected Bond Fund have surged to more than $1.1 billion recently, from $724 million at the end of 2003.

Still, based on the rate of inflation over the past decade -- about 2.4% -- one could argue that TIPS are fairly valued now. Merrill Lynch, for one, has been scaling back its exposure. "The relative attractiveness of TIPS has diminished," says David Magrone, a private wealth adviser in Merrill's Global Private Banking and Investment Group.

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How to Invest in TIPS

Investors are loading up on Treasury Inflation-Protected Securities, which can be purchased directly from the Treasury Department (). There's also a growing number of mutual funds focused on TIPS; here are the five largest, with performance data.

Fund (Ticker Symbol): PIMCO Real Return A (PRTNX)

One-Year Return: 6.1%

Three-Year Annualized Return: 8.6%

Phone Number: 800-426-0107

Fund (Ticker Symbol): Vanguard Inflation-Protected Securities (VIPSX)

One-Year Return: 5.8%

Three-Year Annualized Return: 8.7%

Phone Number: 800-523-3090

Fund (Ticker Symbol): Fidelity Inflation-Protected Bond (FINPX)

One-Year Return: 5.4%

Three-Year Annualized Return: N/A *

Phone Number: 800-343-3548

Fund (Ticker Symbol): American Century Inflation-Adjusted Bond (AIAVX)

One-Year Return: 4.7%

Three-Year Annualized Return: 7.4%

Phone Number: 800-345-2021

Fund (Ticker Symbol): Hartford Inflation Plus A (HIPAX)

One-Year Return: 4.4%

Three-Year Annualized Return: N/A **

Phone Number: 888-843-7824

Note: Return data through May 4, 2004.

* Fund was launched in June 2002.

** Fund was launched in October 2002.

Source: Morningstar, Inc.; WSJ Research

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Write to Jeff D. Opdyke at jeff.opdyke@ and Rebecca Christie at rebecca.christie@

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