Hot TIPS Gain Following

The inflation-protected bonds look better in light of the Fed's new tone.
By Rebecca Byrne ,

A change in tone last week by the

Federal Reserve

has sent investors scrambling for ways to protect against higher inflation and interest rates.

The panic could well be overdone. After all, the Fed vowed to remain "patient" in raising rates, noting that "increases in consumer prices are muted and expected to remain low." The fact that the central bank abandoned its commitment to keep rates on hold for a "considerable period" doesn't suggest that inflation is becoming a problem or that a rate hike is imminent.

But with the economy growing at a fast clip recently, investors are getting worried and some of them are looking for a little insurance. That's where TIPS come in.

TIPS, or Treasury Inflation Protected Securities, are designed to shield investors from the risk of rising inflation. Higher inflation hurts traditional bond investors because it reduces the value of the fixed-income payments they receive. With TIPS, the value of the principal is adjusted periodically to reflect changes in the consumer price index. That, in turn, affects interest payments.

Let's say you invested $1,000 in a 10-year inflation protected security, paying 2% interest annually. At midyear, the CPI shows that inflation has been running at 1% over the past six months. Your principal is adjusted higher to $1,010 and your semiannual interest payment stands at $10.10. After the first year, the CPI shows inflation running at 2% over the past six months. This raises the value of your principal to $1,020 and brings your second interest payment to $10.20.

TIPS have been volatile over the past six weeks as inflation expectations have fluctuated. In mid-December, TIPS underperformed as the core CPI for November showed a decline for the first time in 21 years. But analysts say the spread between 10-year TIPS and traditional 10-year bonds has widened recently, suggesting that investors are again concerned about the prospect of rising prices.

"What we're seeing is there appears to be a preference for

TIPS based on the fact that they've repeatedly outperformed at times when one would have thought they might not have," said Tony Crescenzi, chief bond strategist at Miller Tabak and contributor to

TheStreet.com's

sister site

RealMoney

.

Crescenzi said TIPS have "snapped right back" from any periods of weakness and did well last week even though there was little evidence of inflation in the gross domestic product report.

The Treasury issues about $40 billion annually in 10-year TIPS but economists believe more supply could be on the way. The Congressional Budget Office is now forecasting that the 10-year budget deficit will be about one trillion dollars more than it predicted just six months ago, and the Treasury is looking for a way to fund the shortfall.

Merrill Lynch economist David Rosenberg said the government wants to issue a long dated security to satisfy pension and insurance firms that need a long-term asset to match long-term liabilities. And the Treasury is looking to the TIPS market because issuing a traditional debt security could be seen as a reversal of an earlier decision to retire the 30-year bond.

"The Treasury will likely kick off 20-year issuance in a cautious manner, offering an annual total of $20 billion or so," Rosenberg wrote in a note to clients. "We look for July to mark the inaugural 20-year TIPS auction."

The extra supply isn't expected to push up interest rates significantly because economists say there is likely to be plenty of demand from pension funds and from overseas investors. Central banks in Asia have been purchasing dollars and selling their own currencies in an attempt to keep their exports strong. The dollars have then been invested back into Treasuries.

Analysts also note that one of the big problems with the TIPS market in the past has been liquidity, so extra supply could make for more efficient pricing.

Alex Li, interest rate strategist at Credit Suisse First Boston, said if the Treasury does issue 20-year TIPS this summer, as he expects, they're likely to be very well received by investors.

"Over the near term, inflation is expected to stay low, but over the longer term I think TIPS might benefit investors as an inflation hedge," he said. "The market is expecting inflation to rise eventually."

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