Here are some TIPS

The hot sales of Treasury Inflation Protected Securities show that Bernanke is not whipping up inflation concerns. The market already has them.

Treasury Inflation Protected Securities are the bonds money managers can't afford not to own.

BlackRock Inc., Pacific Investment Management Co. and Vanguard Group Inc., which together manage $3.45 trillion, say investors are pouring money into inflation-linked debt even as consumer prices post the longest series of contractions since Dwight D. Eisenhower was president in 1955. TIPS have gained 7.9% this year, according to Merrill Lynch & Co. indexes, while Treasuries overall lost 2.8%. That's the biggest outperformance since the U.S. first issued TIPS in 1997.

After getting bludgeoned by the subprime mortgage collapse, investors are preparing for another potential crisis: a surge in the cost of living spurred by the $11.6 trillion the Federal Reserve and the government have lent, spent or guaranteed to shore up the economy and the financial system. While inflation is tame now, they see danger signs in the doubling of crude oil futures since January, gold trading at record highs and the 14.5% tumble in the trade-weighted Dollar Index since March.

“Investors are really taking the long view and trying to hedge inflation risk,” says Mihir Worah, who oversees the $15.4 billion Real Return Fund for Newport Beach, Calif.-based Pimco, the world's biggest bond manager. “That's the biggest reason why we're seeing the flows.”

The Real Return Fund's assets under management have increased 25% this year, Worah says. The fund has returned 16.5% since December, according to Bloomberg data. Pimco manages $60 billion in inflation-linked debt.

Returns are accelerating, with TIPS rallying 2% in September, the most this year after a 6% surge in March. Returns are similar elsewhere around the world. Excluding the U.S., a Merrill Lynch index that tracks the performance of inflation-linked bonds has gained 7.63% so far this year.

TIPS returned 1.1 percentage points on average more than Treasuries each year since 1999. In each of the five years when the difference was 2 percentage points or more, inflation accelerated the following year by an average of
0.8 percentage point. The biggest rise was 1.2 percentage points in 1999, with the smallest being a 0.4 point gain in 2004. Consumer prices rose after TIPS outperformed in 2003, 2005 and 2008.

Fed Chairman Ben S. Bernanke said at a Board of Governors conference Oct. 8 in Washington that while “accommodative policies” will be in place for an extended period, the central bank will be prepared to tighten monetary policy “to prevent the emergence of an inflation problem down the road.”

'First brick to fall'
Last week's auction by the Treasury of $7 billion of 10-year TIPS shows the strength of demand for the securities. The Oct. 5 sale drew bids equal to 3.12 times the amount offered, the highest bid-to-cover ratio since January 1999. The notes drew a yield of 1.51%, compared with a forecast of 1.56% in a Bloomberg News survey of seven of the 18 primary dealers that underwrite U.S. debt auctions.

Pension funds, central banks and individuals are all buying TIPS, according to Brian Weinstein, who manages $9 billion of the securities for BlackRock in New York.

“The first brick in the inflation wall to fall is the expectation brick,” says Weinstein. “If people are calling me worried about inflation it means that they're acting differently. It means they're actually starting to worry about inflation, and that should scare the heck out of central banks.”

BlackRock's TIPS fund for individual investors, the Inflation Protected Bond Portfolio, has more than doubled its assets to $1.75 billion from $800 million at the start of the year, Weinstein says, while the firm's overall inflation-linked assets have risen to $19 billion from $12 billion. Weinstein's fund gained 8.2% this year, according to Bloomberg data.

By historical measures TIPS remain cheap. The difference in yield between 10-year TIPS and 10-year notes is 1.86 percentage points, compared with an average of 2.18 over the past five years. The gap, known as the breakeven rate, has been 2 percentage points or more for 79% of that time, Bloomberg data shows.

Weinstein and Pimco's Worah both recommend 10-year TIPS because of the risk falling prices still pose for securities maturing in less than five years.

The Labor Department will report on Oct. 15 that the consumer price index rose 0.2% in September from August, while declining 1.4% from the year-earlier period, according to a Bloomberg survey. It would be the seventh consecutive monthly decline on an annual basis.

Rope-a-dope
“TIPS are the rope-a-dope strategy of the bond market,” said Mitchell Stapley, the Grand Rapids, Mich.-based chief fixed-income officer for Fifth Third Asset Management. Rope-a-dope refers to boxer Muhammad Ali's strategy of hunkering into a protective stance against which his opponent would flail, wearing himself out — at which point Ali would strike. “These things perform best when people are talking about deflation.”

The benchmark 1.875% 10-year inflation-indexed Treasury note ended last week at 103 4/32 to yield 1.53%, according to BGCantor Market Data. The breakeven rate rose 14 basis points, or 0.14 percentage point, in the period, the most in seven weeks. The coupon compares with 3.625% on the benchmark 10-year Treasury.

Investors are willing to accept lower yields on TIPS because the principal increases annually at the rate of the consumer price index. The securities pay semi-annual interest on the adjusted principal. Their face value is protected against deflation, because the principal can't fall below par.

Some policy makers say deflation is a greater threat to economic recovery than inflation.

“We would not need much of a decline in inflation to run the risk of an outright deflation,” Fed Bank of New York President William Dudley said in a speech in New York on Oct 5. “Outright deflation, in turn, would be a dangerous development because it would drive up real debt burdens and make it much more difficult for households and businesses to deleverage.”

Investors concerned about falling prices should buy long- term Treasuries, says Alex Li, an interest-rate strategist in New York at primary dealer Credit Suisse Group AG.

The benchmark 30-year bond, a 4.5% security due August 2039, closed last week at 104 20/32 to yield 4.23%, or 3.26 percentage points more than the two-year note. The so- called yield curve is steeper than the mean of 1.5 percentage points over the last 20 years.

“At the beginning of next year or later this year people are going to realize low inflation's going to stay with us at least over the near- to medium-term,” Li says. “That's the time when TIPS are going to suffer.”
TIPS risk

September's larger-than-forecast decline in non-farm payrolls indicates the recovery may take more time to take root. A sluggish economy is a negative for TIPS investors, who could lose money if consumer prices rise on average less than the 1.86% breakeven rate.

“The risk to owning TIPS would be a double-dip zero percent or negative inflationary period for a number of years,” says Kenneth Volpert, who oversees $180 billion as head of taxable fixed-income at Vanguard Group in Valley Forge, Pa.

TIPS holders also run the risk of getting burned if the Fed begins raising interest rates “with greater force than is customary,” as Fed Governor Kevin Warsh warned on Sept. 25, when an economy recovery takes hold.

The Fed has kept its target rate for overnight loans between banks at zero to 0.25% since December in an effort to hold down borrowing costs and boost lending. The seizure in credit markets triggered $1.62 trillion of writedowns and credit losses at financial institutions since the start of 2007, sending the global economy into its first recession since World War II.

Inflation expectations as measured by the Fed's five- year/five-year forward breakeven rate rose to 2.80 percentage points on Oct. 6 from a low of 2.03 percentage points on Nov. 20. The rate plots forward rates measuring investor expectations for inflation in five years. The gauge was at 3.06 percentage points on June 30, 2004, when the Fed last raised its target rate.

Crude oil futures are more than double their January low of $32.70. Spending by U.S. consumers climbed by 1.3% in August, the most since 2001, and followed a 0.3% gain in the prior month that was bigger than previously estimated, the Commerce Department reported on Oct. 1 in Washington.

The cost of living will rise 2.3% in 2011, according to the median estimate of 45 forecasters in another survey that puts a greater weighing on the most recent projections.

Karthik Ramanathan, the Treasury Department's acting assistant secretary for financial markets, said on Oct. 1 during a speech in Boston that the Treasury is considering boosting issuance of TIPS as much as 70% to $100 billion
in 2010, particularly the extension of “longer-dated TIPS by shifting issuance from 20-year TIPS to 30-year TIPS.”

The breakeven rate on 10-year TIPS may rise to 4 percentage points in two years, according to John Brynjolfsson, chief investment officer of Aliso Viejo, California-based hedge fund Armored Wolf, as record budget deficits, expansionary monetary policy and a “debased currency” spur inflation. Gold, which reached an all-time high of $1,062.70 on Oct. 8, could reach $2,000 an ounce by 2012, he said.