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A New Leader in the Bond Derby

With Wall Street pundits fixated on deflation, the idea of buying Treasury bonds that protect you against inflation seems as crazy as preparing for a communist takeover. But guess what? Treasury Inflation-Indexed Securities are actually a great deal right now. Even if the consumer price index rises only 1.7% annually over the next three decades a mere tenth of a percentage point above the current rate buy-and-hold investors will be better off with 30-year inflation-protected securities, commonly known as TIPS, than with conventional Treasuries. TIPS have yet to catch on with individual investors, who have bought only a fraction of the $75 billion issued so far, says Dan Bernstein, research director at Bridgewater Associates, a Westport (Conn.) money manager. Individuals have shied away from TIPS because they re hard to understand and less liquid than ordinary Treasuries.

Slowing inflation has also given people a reason to stay. If you buy a conventional $1,000, 30-year bond at today s 5.5% rate, you are guaranteed $55 in interest payments each year, no matter what the inflation rate is, until you get your principal back in 2029. Let s say you buy TIPS, now yielding 3.9% plus an adjustment for the consumer price index, and inflation falls to 0.5% from the current 1.6%. Because of the lower inflation rate, you ll get only $44 annually. Nevertheless, even if the economy falls into deflation, you ll get the face value of the bonds back at maturity.

Less Volatile

But if inflation spikes up, TIPS would outshine conventional bonds. For example, a $1,000, 30-year TIPS with a 4% coupon would yield $40 in its first year. If inflation rises by three points, your principal would be worth $1,030. The $30 gain plus the interest would translate into a 7% total return.

TIPS are attractive for another reason: They re onequarter to one-third as volatile as conventional Treasuries because of their built- in inflation protection. So investors who use them are less exposed to risk, says Christopher Kinney, a manager at Brown Brothers Harriman. As a result, a portfolio containing TIPS can have a higher percentage of its assets invested in stocks, potentially boosting returns without taking on more risk. Even so, the price of TIPS can change. If the Federal Reserve hikes interest rates, they ll fall. If it lowers rates, they ll rise. That won t be a concern if you hold the TIPS until maturity, of course.

What are the differences between the bond s coupon rate, current yield, and yield to maturity?

A bond is a long-term debt of a government or corporation. When you own a bond, you receive a fixed interest payment each year until the bond matures. This payment is known as the coupon. The coupon rate is the annual coupon payment expressed as a fraction of the bond s face value. At maturity the bond s face value is repaid. In the United States most bonds have a face value of $1,000. The current yield is the annual coupon payment expressed as a fraction of the bond s price. The yield to maturity measures the average rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value.

How can one find the market price of a bond given its yield to maturity and find a bond s yield given its price? Why do prices and yields vary inversely?

Bonds are valued by discounting the coupon payments and the final repayment by the yield to maturity on comparable bonds. The bond payments discounted at the bond s yield to maturity equal the bond price. You may also start with the bond price and ask what interest rate the bond offers. This interest rate that equates the present value of bond payments to the bond price is the yield to maturity. Because present values are lower when discount rates are higher, price and yield to maturity vary inversely.

Why do bonds exhibit interest rate risk?

Bond prices are subject to interest rate risk, rising when market interest rates fall and falling when market rates rise. Long-term bonds exhibit greater interest rate risk than short-term bonds.

Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings?

Investors demand higher promised yields if there is a high probability that the borrower will run into trouble and default. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. The additional yield investors require for bearing credit risk is called the default premium. Bond ratings measure the bond s credit risk.