The 0.7% increase in the consumer price index in April put inflation fears on the map again, causing a renewed interest in inflation-indexed bonds.
"Inflation expectations have increased dramatically, by 100 basis points," said John Brynjolfsson, portfolio manager for real return products and an expert in inflation-indexed bonds at Pacific Investment Management Co. PIMCO, based in Newport Beach, Calif., manages more than $8 billion in inflation-indexed bonds, both in the PIMCO Real Return Bond Fund and in separate accounts.
Mr. Brynjolfsson believes the spike in oil prices in February and the fighting in Kosovo also helped to "put inflation back on the radar screen."
He pointed out the real return on the inflation-indexed bonds, known as Treasury Inflation Protection Securities, has outperformed nominal bonds. TIPS are "very sensitive to changes in real interest rates," he said. Year-to-date as of June 23, the Lehman Aggregate Bond index returned -2.35%, he said, while the TIPS index returned 1.75%.
"The consulting community has boned up on these bonds and is talking to their clients in a proactive and reactive manner," he added.
"The level of interest has increased. It has changed from curiosity and (an interest in) background information to questions involving implementation."
Wake Forest University, Winston-Salem, N.C., just made a $15 million investment in inflation-indexed bonds with PIMCO about six weeks ago, according to Louis R. Morrell, vice president and treasurer, who oversees the university's $860 million endowment.
The interest in these bonds began when a new trustee on Wake Forest's board expressed concern about the university's inflation risk. "We did a risk analysis for the university as a whole," Mr. Morrell said, "and saw that we have a lot of inflation risk."
It explored other inflation hedges such as commodities and managed futures, but decided inflation-indexed bonds were the best choice.
"We'll probably add to the position," he said, "particularly if inflation stays down -- it will be a buying opportunity," he said. "We think it will play a big part in our investment-grade bond portfolio."
"The real yield on TIPS of 4% is very attractive," said Norman Cumming, managing director and head of fixed-income investments at UBS Brinson, Chicago.
"A sizable number of pension fund clients have given us permission to use TIPS" in fixed-income and balanced portfolios, he added. Brinson has owned as much as $2 billion in TIPS recently, according to Mr. Cumming.
TIPS also are useful "for any situation where there are long-term liabilities," such as pension funds have, said Mr. Cumming. "TIPS are a very good way of matching liabilities."
Brinson sends quarterly reviews to its clients, in which inflation-indexed bonds have been discussed. "As these pieces go out we get interest from clients who see that we use the strategy," said Jamie Jackson, head of U.S. government securities at Brinson.
"We are encouraging our clients to look at inflation-indexed bonds as a separate asset class from fixed income," said Robert Prince, director of research at Bridgewater Associates, Westport, Conn. "If inflation-indexed bonds are added to a portfolio, (it) is more diversified."
He pointed out that if inflation rises, interest rates will go up while stock prices likely will go down. "When inflation rises, the return on inflation-indexed bonds will rise and it will be an excellent diversification from stocks," Mr. Prince said.
The nominal Treasury bond yield is now 6%, according to Mr. Prince, while the yield on inflation-indexed bonds is 4% plus whatever the inflation rate is. "If you think the inflation rate will be more than 2%," you should buy inflation-indexed bonds, he added.
Diversification and concern over inflation are the reasons investors are putting their money in inflation-indexed bonds, Mr. Prince said. According to his clients, 70% are investing in inflation-indexed bonds for diversification reasons and 20% to 30% are investing in them because of inflation concerns.
"TIPS represent a fourth asset class," Mr. Brynjolfsson said. "There are equities, bonds, cash and inflation hedges (for which TIPS are used).
"Traditional bonds protect an organization from deflation, while inflation hedges protect against inflation," he said. "Equities have been thought of as an inflation hedge, but they are one of the poorest inflation hedges we have."
He pointed out that there have been extended periods when equity prices didn't appreciate at all, such as from 1968 to 1983. "It's exactly for periods like that, when equities do poorly, (nominal) bonds aren't quite as bad, that you need inflation-hedges," he said.
While that is far from the case today, he said, it could happen.
Jack Cutler, director of pension and thrift management for Asea Brown Boveri Inc., Stamford, Conn., said, "We think (inflation-indexed bonds) represent an attractive asset class for plan sponsors with liabilities denominated in real terms."
The ABB pension plan has about $1.1 billion in assets.
"I don't take a view on inflation," he added. "I do feel if you have liabilities denominated in real terms, you use TIPS to immunize against real-term liabilities."
He explained that if a pension fund has to pay cost-of-living increases to retirees based on inflation -- a real rate of return -- TIPS that pay $100 today, with interest rates that will rise along with the CPI, provide protection for the pension fund. "I can give you the benefit regardless of what inflation does," he said.
But not everyone thinks inflation-indexed bonds are good. Thad Carlson, a vice president and treasury strategist with J.P. Morgan Investment Management Co., New York, said "TIPS trade erratically vs. nominal bonds. TIPS can add tracking error for (a manager) who's benchmarked against an index (that doesn't include TIPS).
"Nominal bonds could do well but TIPS might just sit there (and not rally), so you underperform (the benchmark)."
TIPS are unstable, Mr. Carlson said. "Sometimes the market rallies and they won't move at all and sometimes they rally considerably. You never know how they're going to react. Liquidity is not very good in this market."
Moreover, "the Federal Reserve is trying to increase real (interest) rates to slow the economy. But it's more likely that nominal bonds will rally rather than TIPS."
He does not believe inflation will be a problem any time soon.
Keith Anderson, chief investment officer-fixed income, BlackRock Inc., New York, said TIPS "underwent a recent resurgence when the CPI was released (for April) and came in so high." However, he added that much of the gain has dissipated in the last couple of weeks, since the CPI had no rise in May.
