WASHINGTON - Inflation-indexed bonds are at the top of the charts these days, and it's easy to see why.
While the S&P 500 index lost 13.15% and the Lehman Brothers Aggregate Bond index posted total returns of 3.79% for the first half of the year, inflation-indexed bonds - or Treasury Inflation Protected Securities, as they are formally known - logged sizable total returns of 7.5% for the same period, according to the Barclays Capital U.S. Inflation-Linked Bond index.
Add the advantages of diversification that institutional investors are desperately seeking, and it becomes apparent why inflation-indexed bonds are hot, sources say.
Although commodities and real estate also provide diversification in an investment portfolio and a hedge against inflation, some experts point to the high volatility of commodities and the illiquidity of real estate as major disadvantages. Inflation-indexed bonds insulate against inflation and have little or no correlation with other asset classes and low volatility, academic studies show.
And, investment experts and institutional investors expect that inflation-indexed bonds might retain their spot at the top for years.
"We are in for a period of a number of years of fairly modest absolute returns for stocks and bonds. In that environment, (investors) really need to take a look at TIPS because you're getting 3% plus inflation," said Michael Rosen, a principal at Angeles Investment Advisors LLC, a Santa Monica, Calif.-based consulting firm.
Casey Colton, vice president and portfolio manager of the American Century Inflation-Adjusted Fund in Mountain View, Calif., agrees. "We're seeing increasing interest from plan sponsors for that asset class," said Mr. Colton, whose fund has more than tripled to $230 million in assets, from $74 million a year earlier.
Gemma A. Wright, director of market research at Barclays Capital, New York, a primary dealer in U.S. Treasury securities, adds, "As the economy recovers, there is an inherent risk that inflation accelerates, and TIPS should provide protection in that environment."
The $36 billion Virginia Retirement System, Richmond, which will begin reviewing its asset allocation in August, will consider whether to invest in inflation-indexed bonds as a separate asset class. The system currently lets its bond managers use TIPS opportunistically.
Smith College, Northampton, Mass., is adding inflation-indexed bonds to its $900 million endowment, said Jay Yoder, director of investments. The college expects to allocate between 2% and 3% of total assets to a TIPS portfolio, which will be managed internally, he said.
Meanwhile, Fidelity Investments, Boston, confirmed plans to launch an inflation-protected bond mutual fund in the third quarter.
And the Florida State Board of Administration, Tallahassee, invested $340 million of its $8.5 billion active government bond portfolio in TIPS last year as a tactical bet against nominal bonds, said Debbie McCoy, portfolio manager. "It's the only investment that will guarantee a real rate of return, so we wholeheartedly agree there is a place in the portfolio for TIPS," she said.
The heightened interest in inflation-protected bonds is fueled, at least in part, by the aggressive campaign begun earlier this year by the Treasury Department to assure investors they are an integral part of the government's debt management strategy.
Uncertainty last year about the Bush administration's plans for continuing the program kept many investors at bay. But now, senior Treasury officials maintain that five years is not enough to judge the program's feasibility, and a review is not scheduled for at least another five years.
Treasury officials also are attempting to boost the popularity of the securities by actively seeking investors' suggestions on ways of increasing liquidity - plan sponsors that have so far stayed away from them TIPS often cite illiquidity as the reason. The TIPS market is $139 billion, or 4.6% of the total outstanding Treasury debt. This year, investment experts estimate the Treasury will issue anywhere between $12 billion and $16 billion in 10-year TIPS.
"Because Treasury inflation-indexed securities are a unique asset class - dollar-denominated, inflation-protected, backed by U.S. full faith and credit - we think every diversified investor should own some," Assistant Treasury Secretary Brian C. Roseboro said in a speech to foreign central bankers last month. "We are looking for suggestions on how to deepen the market for the 10-year inflation indexed security," he added.
The Treasury's publicity campaign promoting TIPS seems to be working.
Moreover, because the bonds were first issued in January 1997 and now have five-year performance data available, investment consultants have begun recommending them to clients as a separate asset class (institutional investors rarely invest in assets without a five-year track record). More than 100 institutional investors and consultants attended Barclays' conference on inflation-indexed bonds in January, a far cry from the eight investors who attended the first conference just five years ago, Ms. Wright observed.
"Word has gotten around," said Christopher F. Kinney, senior vice president at Brown Brothers Harriman. Mr. Kinney runs the 59 Wall Street Inflation-Indexed Securities Fund, which returned 5.55% for the year ended March 31, and 7.06% since inception in late February 1997. TIPS have been "stellar performers" since the second quarter of 2000, he notes.
The Treasury Department is increasing new issuances of TIPS from twice a year to three times a year. Ms. Wright estimates the Treasury will auction as much as $8 billion in 10-year TIPS on July 15, or about as much as the Treasury auctioned at the beginning of the program in the late 1990s.
William L. Tedford Jr., director of fixed-income strategy and senior vice president at Stephens Capital Management, Little Rock, Ark., already has 25% of the $500 million he manages in an intermediate bond portfolio in TIPS. He plans to load up even more toward the end of the year, when he expects inflation will begin rising. "I will probably double my position in TIPS," Mr. Tedford said.