Fidelity Offering TIPS to Investors

Fidelity Investments is launching a new bond fund aimed at investors who are concerned about rising inflation.

The new fund will hold U.S. Treasury inflation-protected securities, or TIPS, which were introduced by the federal government in 1997. The bonds' principal is adjusted to rise with inflation; specifically, the principal rises in accordance with the consumer price index.

Fidelity is slightly behind the curve in introducing its TIPS fund, although the timing is sound: The small universe of TIPS funds (Lipper tracks just six such funds) has done very well of late. Pimco's Real Return Fund (PRTNX Quote)PRTNX, the first inflation-protected bond fund, was opened on the day of the initial TIPS auction in 1997 and now has nearly $4 billion in assets. Vanguard's $1.4 billion Inflation Protected Securities fund (VIPSX Quote)VIPSX, the second largest, was introduced in June 2000.

The two funds are also the best-performing of the group. Pimco's actively managed fund has returned 6.3% this year, while Vanguard's index fund gained 6.1%.

TIPS have greatly outpaced standard Treasury bonds. The Lehman Brothers TIPS index returned 5.9% in the first five months of 2002, while Lehman's Treasury index has returned just 2.2% in the same period. "TIPS have had a real good run vs. nominal Treasuries and even international inflation-protected bonds," says Bob Greer, Pimco's real-return product manager. "And we don't think the run is over. There's still concern about rising inflation."

And it's the concern about inflation that drives TIPS returns -- not necessarily actual inflation. But that concern is justified: After several years of low inflation, most economists predict rising inflation, with the rate expected to be between 3% and 4% in 2003.

Right now, the so-called "break-even" rate of inflation -- the point at which there's not much difference to investors whether they purchase traditional government bonds or TIPS -- is 2.2%. In other words, investors who think inflation will rise more than 2.2% in the next few years -- which most economic forecasts predict -- will flock to inflation-protected TIPS.

TIPS are a hedge -- they do better than bonds when inflation is rising but less well when deflation occurs. In the case of deflation (defined as a decline in the prices of goods and services, not to be confused with disinflation, which is a slowing down in the rate of price increases), TIPS' principal is protected by the government's guarantee to repay investors at least their original investment.

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Take the case of an investor who purchases a $1,000 conventional 10-year note with a 5% annual coupon interest payment. That investor will receive $50 annually for 10 years and the original $1,000 back at maturity for a total of $1,500. How much that $1,500 can buy 10 years from now, though, depends entirely on the rate of inflation. If inflation increased 4% annually over the 10-year period, the real value of the note's 5% interest payment would have fallen 4% annually, which means in the 10th year, the $50 interest payment is worth just $33.75, after adjusting for inflation. Plus, the real value of the principal will be $675, rather than $1,000. In this example, the conventional bond didn't keep up with inflation.

In the case of TIPS, both the principal and interest payment increase to reflect any rise in inflation. Essentially, if inflation rises 4% per year on a $1,000 10-year TIPS note with a 3.5% annual coupon, the principal would have been adjusted upward to $1,480 at the end of the 10 years, and the interest payment made in the 10th year would be 3.5% of the inflation-adjusted principal, or $51.81.

There is a catch to all this, though. (Isn't there always?) Although exempt from state and local taxes, investors owe federal ordinary income tax (as much as 38.6%) on both the inflation-adjusted piece of the principal and the annual interest. Investing in TIPS through a mutual fund does not save investors any tax; the fund will simply pro-rate the taxable inflation-adjusted amount each year.

One tax savings option, though, is to keep TIPS funds in a tax-advantaged account, like an IRA or 401(k) account. If a TIPS fund is in a tax-favored retirement (or education) account, investors can avoid the annual income tax burden.