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 August 27, 2003

From the Archives: Getting Going

The World's 'Safest' Investments
Still Carry Risk of Painful Losses


Inflation-indexed Treasury bonds are possibly the market's safest investment. But you could still suffer stinging losses.

When the Treasury Department announced seven years ago that it was bringing out inflation-indexed bonds, I was among those jumping up and down, hollering about the opportunity at hand. But I fear that, amid all the hollering, folks have lost sight of the risks involved.

The fact is, inflation bonds can post nasty short-term losses. Take Vanguard Inflation-Protected Securities Fund. After being up over 9% earlier this year, the fund's year-to-date gain is now 2.9%. And if the recent bloodbath in the bond market resumes, even that 2.9% could quickly slip away.

"Investors may have imputed some sort of magic to inflation-indexed Treasury bonds," worries John Hollyer, a senior fixed-income portfolio manager at Vanguard Group in Malvern, Pa. "They see that the two biggest risks, credit risk and inflation risk, aren't there. But over short periods, they could suffer big declines in value."

With inflation-indexed bonds, you are protected against inflation and you don't have to worry about defaults, because the bonds are backed by the U.S. government. But if rates turn against you -- as they have this year -- you can lose money in a hurry.

Despite the recent drubbing, inflation-indexed bonds remain a great addition to a portfolio, for two reasons. First, the bonds offer a guaranteed return above inflation, something you can't get from either conventional bonds, with their fixed nominal yield, or from stocks. Second, they are a great diversifier for a portfolio that is heavily invested in these other investments.

If you own stocks and conventional bonds, one of the biggest threats is accelerating inflation. The accompanying rise in interest rates will drive down the price of conventional bonds and will probably also hurt stock prices. But under the same scenario, inflation-indexed bonds should fare reasonably well, thanks to their built-in inflation protection.

Price Protection

Below are five of the cheaper no-load inflation-indexed bond funds open to small investors.

American Century Inflation Bond 0.51% $2,500
Fidelity Inflation- Protected Bond 0.5 $2,500
T. Rowe Price Inflation-Protected 0.5 $2,500
TIAA-CREF Inflation-Linked 0.3 $2,500
Vanguard Inflation-Protected 0.22 $3,000

Source: Morningstar Inc.

With inflation-indexed Treasurys, the principal value of your bonds is stepped up along with the consumer-price index. Inflation-bond investors also earn a small "real" yield, which represents their return above inflation. Currently, 29-year inflation-indexed bonds yield 2.7% above inflation, while 10-year inflation-indexed notes offer a real yield of 2.3%.

I have often heard bond investors say that they look to earn 3% a year above inflation from conventional long-term Treasurys. On that basis, 29-year inflation-indexed Treasurys seem like a reasonable bet. You are getting 2.7% above inflation and, unlike conventional Treasurys, that inflation-beating gain is guaranteed.

Sound tempting? While the promised long-run return might seem attractive, keep in mind that you have to live with all the short-term turmoil. "At some point, we're going to have a bear market in inflation-indexed Treasury bonds and people will bail," says William Bernstein, author of "The Four Pillars of Investing." "They're a pretty volatile asset."

Even if you can shrug off this volatility, you face a second headache. Every year, investors have to pay income taxes on both the yield they receive and the inflation-driven increase in their bonds' principal value.

The problem: If inflation is high enough, investors may find they are losing their entire real yield to Uncle Sam. Suppose you are in the 35% income-tax bracket and you buy 10-year inflation bonds with their 2.3% real yield. If inflation runs at 4.7% over the next decade, you will clock a nominal gain of 7%. But after you surrender 35% of that gain to the taxman, you will be left with less than 4.6%, below the 4.7% inflation rate.

"These things are horribly tax-inefficient, because of the tax on the phantom income," says Nelson Lam, an investment adviser in Lake Oswego, Ore. "For that reason, they are best held in tax-sheltered accounts." That tax sheltering allows you to postpone the tax bill, helping to bolster your after-tax performance.

What if you don't have any more room in your individual retirement account and you can't buy inflation bonds in your 401(k), because it isn't one of the plan's choices? What if you are worried that real yields will rise, driving down the value of inflation-indexed Treasurys even further?

One option is to buy Series I savings bonds. I bonds also provide a guaranteed return above inflation. But the bonds don't fluctuate in value and you don't have to pay income taxes on your earnings until you cash in your savings bonds.

If you buy I bonds today, however, I wouldn't plan on holding them for very long. Why not? If you go to www.treasurydirect.gov, the Treasury Department is advertising a nominal yield on I bonds of 4.66%. But that yield is deceptively high, the result of a spurt in inflation earlier this year. The after-inflation yield is a miserable 1.1%.

What to do? You could hold off buying I bonds until Nov. 1, when the real yield is next reset, in the hope of getting a higher interest rate.

Alternatively, you could buy I bonds today, with the idea of swapping into inflation-indexed Treasury bonds or newer I bonds, if the yield on either becomes temptingly high. But be warned: You can't sell your savings bonds in the first year. Moreover, if you sell in the first five years, you will lose your last three months of interest.

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