Scared investors flock to TIPS as inflation hedge

Inflation fears and attractive returns are driving demand for Treasury Inflation-Protected Securities.

Year-to-date through July 31, the Department of the Treasury sold $548 billion of TIPS, compared with sales of $516 billion in the first seven months last year.

During the same period, investors poured $5.8 billion into the three exchange traded funds that invest in TIPS and a net of $9.6 billion into 40 inflation-protected-bond mutual funds tracked by Morningstar Inc. of Chicago.

“It’s clear that inflation is on everyone’s mind. You have a lot of boomers shifting from asset appreciation to income, and the universal killer of fixed income is inflation,” said Scott Burns, an ETF analyst at Morningstar.

“You make sure you have a portion of your investment protected from inflation,” he said. “You don’t buy flood insurance when the river is in your living room.”

Available since 1997, TIPS are bonds issued by the Treasury Department in which both the coupon interest and principal are adjusted for inflation as measured by the Consumer Price Index. Last week, the coupon rate on 20-year TIPS bonds was 2.17%; the coupon on comparable-term Treasury bonds that don’t adjust principal or interest for inflation was 4.29%.

Last year, as fearful investors scrambled for safety, the prices of conventional Treasury bonds soared above the prices of TIPS.

“There was a flight to liquidity,” said John Hollyer, co-portfolio manager of the $22.3 billion Vanguard Inflation Protected Securities Fund (VIPSX) offered by The Vanguard Group Inc. of Malvern, Pa.

But now that the crisis has passed, TIPS look more promising. Bonds measured by the Barclays Capital U.S. TIPS Index had a year-to-date yield of 7.24% through Aug. 19, while bonds measured by the Barclays Capital U.S. Treasury Index had a loss of 3.46%.

Attracted by those returns, net inflows at Mr. Hollyer’s fund increased 25% year-to-date through June 30, compared with the same period of last year.

Many advisers have begun adding TIPS to portfolios.

Portfolio managers at Brinker Capital Inc. in Berwyn, Pa., which provides investment management programs for advisers, began adding TIPS in March with an allocation of under 7%, said Amy Magnotta, a portfolio manager and senior investment analyst at the firm, which manages $7.8 billion in assets.

“Right now, TIPS represent a good buying opportunity,” she said. “The price has been cheap.”

Brinker may add more over the next few months if TIPS continue to present a buying opportunity, Ms. Magnotta said, though not because she fears an imminent inflationary flare-up.

“We think inflation is more of a longer-term problem and not a 2010 issue. If the Federal Reserve keeps interest rates low for an extended period, we might see inflation sooner than two years from now, but we are still in the camp that believes it’s not going to be a problem this year or next,” Ms. Magnotta said.

“Our goal is to build the allocation to TIPS over time,” she said.

Managers at Osborn & Scarborough LLC of San Francisco, which manages $1.7 billion in assets, increased the firm’s average allocation to TIPS to 6%, from 3%, in the past two months, said Clay Ernst, a portfolio manager at the firm.

“We make moves incrementally,” said Mr. Ernst, who also thinks that inflation will heat up in two to five years.

In the meantime, like many advisers, he thinks that deflation is as much of a threat as inflation. Mid-month figures from the Federal Reserve showing the economy’s capacity utilization at 68.5% drove home the point, Mr. Ernst said.

“It means that one-third of the manufacturing capacity in the U.S. is dormant,” he said.

“An additional 12% to 15% of capacity could be turned on with a switch. That will constrain any upward price movement,” Mr. Ernst said.

Deflation is also the direction in which Kevin Young’s economic compass points, though he thinks that inflation may reappear “as early as next year.”

“We’re likely to see high rates of inflation in the next 12 to 24 months,” said Mr. Young, principal of Young Wealth Management LLC of Davis, Calif., which manages $10 million in assets. The firm currently allocates 5% to 10% of the assets in an average portfolio to TIPS, he said.

“The government is building huge deficits, printing money and keeping a zero-interest-rate policy, which is leading to a big inflation risk in the years ahead,” said James Shelton, chief investment officer at Kanaly Trust Co. The Houston-based firm manages $2 billion in assets.

The firm has allocated about 12% of its average portfolio to investments designed to hedge inflation, including 5% to TIPS. But it isn’t ready to add more.

“We don’t believe that inflation is a risk today; it’s probably at least a year away,” Mr. Shelton said.

E-mail Sue Asci at [email protected].