NFIB

An Investment TIP for Unsure Times
03/ 05/ 2002

by William J. Lynott

The economic instability brought on by the terrorist attacks is likely to be with us for some time. More than ever, keeping the overall safety of your assets should be a prime concern while the economy takes time to sort itself out.

One investment option you need to consider is a new kind of super-safe U.S. Treasury bond called Treasury inflation-protected securities, or TIPS.

"For the long-term investor, these are the closest thing to a risk-free asset," said William Lloyd, director of research at Barclays Capital, a leading dealer of the bonds. "With TIPS, the Treasury is attracting people who may have never bought Treasuries before. By expanding the market in the long run, they actually lower the overall cost of funding for the government."

A Treasury advisory committee recommended in May that sales of the bonds stop. The panel is made up of representatives of 20 bond dealers and institutional investors, including Goldman Sachs, Merrill Lynch, and Salomon Smith Barney. That kind of world-class opposition makes these securities mighty tempting.

TIPS, introduced in 1997, are structured to provide a base rate of return, plus an additional amount roughly equal to the inflation rate. As of the most recent Treasury auction, TIPS provided a base return of 3.5 percent for a 10-year issue maturing in January 2011. In addition, the principal is adjusted periodically to reflect changes in the Consumer Price Index; when inflation rises, the principal rises with it. Interest is paid twice a year, based on the adjusted principal.

Unlike TIPS, traditional Treasury issues are not guaranteed to keep up with inflation. A traditional 10-year Treasury bought for $10,000 is cashed in at maturity for $10,000; it pays interest twice a year. A 10-year note maturing in February 2011 yielded 5.28 percent recently.

The important question is whether inflation will rise enough to make up for the difference between the base return of TIPS and the yield on traditional Treasuries. This difference, or implied inflation rate, was 1.78 percent recently. If inflation over the life of the bond is less than 1.78 percent, on average, then the regular Treasury bond will turn out to be a better deal. If, on the other hand, inflation is higher than 1.78 percent, TIPS will be the better option. Personally, I don't see inflation at less than 1.78 percent any time in the near future, so TIPS look like a very good deal to me.

TIPS are issued three times a year and you can buy them directly from the Treasury in denominations starting at $1,000. Your next chance is in January. You can also buy or sell TIPS at any time for a fee through your broker.

Experts who favor TIPS say many dealers oppose the bonds because they are intended for the buy-and-hold investor, not for traders. That may well be true since dealers make their money from volume and TIPS don't turn over very much. Before investing, check with your financial advisor to see if TIPS are right for you.

Lynott is the author of Money: How to Make the Most of What You've Got(iUniverse.com, $19.95).

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This article originally appeared in the November/December 2001 issue of MyBusiness Magazine, NFIB's member magazine.

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