As investors have realized that equities are an imperfect
shield from inflation, there has been growing demand for products designed
especially to hedge this risk. The most popular is the U.S. government-issued
TIPS—Treasury Inflation Protected Securities. But there are also new mutual
fund, managed account, structured product and derivatives instruments on offer
that may be of use to private investors.
Straight Tips
The government began issuing TIPS in 1997, and it is now a
mature and easily accessible product. “This is a market that has grown pretty
rapidly and has liquefied nicely—bid-ask spreads are now equal to the most
liquid corporate bonds,” says George Oberhoffer, a senior practice consultant
with Russell Investment Group, based in Tacoma, Wash. “Government-issued TIPS
are far and away the most realistic option for a lot of investors.”
TIPS have
a payoff that changes in line with the CPI for urban areas (CPI-U), published
monthly by the Bureau of Labor Statistics. They perform well in a rising
interest rate environment, but usually underperform other government bonds when
inflation falls or is stagnant. Paul Greff, principal at State Street Global
Advisors in Boston, explains that, despite the low level of inflation in recent
years, it has been enough to boost the otherwise anemic performance of this
instrument. “In the U.S., TIPS have probably been the single largest generator
of excess returns over the last four years because we have seen real returns
falling faster than nominal returns, which has given investors higher-price
returns on TIPS,” he notes.
Just as with ordinary Treasury securities, TIPS
pay a coupon that is a fixed percent of the principal amount. Unlike
conventional bonds, however, the TIPS principal value is adjusted to reflect
changes in the CPI-U. That means their price is very different from conventional
Treasuries. If a typical 10-year bond had a yield of 4.25 percent, its
inflation-linked counterpart might come with a stated yield of around 1.65
percent. Note, however, that the latter figure is a real (inflation-adjusted)
yield, whereas the former is not. To get the real yield of the conventional
bond, you have to deduct inflation from its (nominal) yield. If inflation turns
out to be 2.5 percent over the life of both bonds, then the real yield on the
nominal bond is actually just 1.75 percent, much closer to the
inflation-protected security. If inflation in this example exceeds 2.6 percent,
the TIPS will begin to outperform the conventional Treasury bonds.
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