'TIPS' for Getting Safe, High Returns
By John Dizard

(FORTUNE Magazine) – So, what do you like in the market? I always dread that question. My mind flashes forward to a scene years from now, when someone who has taken my advice rises from the gutter where it put him to harangue me about the awful things I told him to buy.

For the past couple of years, though, I've had a safe, simple response: Buy TIPS, or Treasury inflation-protected securities. Those are T-bonds that pay a fixed coupon, but with a principal value that is adjusted to the latest consumer price index. Right now, they pay a return after inflation of almost exactly 4%.

There are two great reasons for touting TIPS. First, no one who buys them will lose a penny of principal. Second, the tippees will be so bored with the advice that they'll never ask me about the market again. Usually what people want to hear about is a stock that will triple their money, not the prudent preservation of capital.

That's probably why yields on TIPS are at record levels. By historical standards, 4% is a very high real return on bonds. The real, after-inflation return on the regular ten-year U.S. Treasury bond has averaged only 2.73% over the past 40 years. Across all the developed world's bond markets, the historical average is around 2.6%. Not very impressive if you had held AOL from the beginning of the year through April. Very impressive if you've held it from April until now.

So what's the catch? Why is someone willing to do you this favor? The someone in this case is Larry Summers, the Secretary of the Treasury. As Deputy Secretary in the mid-1990s, Summers was the champion of TIPS. Inflation-indexed bonds seemed like a great idea at the time, and economists had long urged the government to issue them. But they're not looking so hot for the government right now. The flip side of the high returns for investors is the high cost for the issuer. The Treasury is probably paying you between 50 and 100 basis points (0.5% to 1.0%) more than it should, on a total of more than $80 billion. So what could be more satisfying? You're making extra money because an arrogant former Harvard academic figured you wouldn't, and the federal government is picking up the tab.

"They've never really found a home," says Paul Zemsky, a managing director of J.P. Morgan Investment Management and the firm's top bond strategist. The problem, he explains, is that the TIPS don't seem to behave much like bonds, and we know they're not stocks, so the consultants who advise a lot of the institutional money in the country don't know where to put them. On the other hand, Zemsky says, "I'd feel comfortable having my mother buy these."

But not all professional investors have ignored TIPS. Ray Dalio, CEO of Bridgewater Associates, a private $20 billion-plus fund, is probably the largest holder of inflation-indexed bonds in the world. Out of a total international market of inflation-protected government bonds of $220 billion or so, he holds $2.5 billion. "Other managers can't tell if these are cheap or expensive," he says. "We have a proprietary model that compares these with the nominal [regular, inflation-vulnerable] bonds and to the indexed bonds that are issued by the other countries." By way of comparison, the real return on British inflation-indexed bonds is 2.11%; French, 4.01%; Canadian, 4.01%; and Australian, 3.8%. Mind you, that doesn't take account of your risk on the exchange rate for the currencies. Considering that, Dalio says, "you are getting a premium on the U.S. TIPS of just over 50 basis points."

What's the best way to buy these things? There are a few mutual funds that are dedicated to TIPS, including ones managed by American Century, Brown Brothers, and Pimco. But you pay between 51 and 65 basis points a year in management fees and expenses.

Better to buy your TIPS directly from the Treasury in its twice-yearly auctions. As a member of the public, you'll get in line to buy them ahead of the professional dealers. And you won't be crowded out by the day-trading community. The TIPS auctions have an unusually small participation by the "noncomps" (as the "noncompetitive" small investors are called). Look up Treasury Direct on the department's Website (www.ustreas.gov).

You might also be able to get your hands on some U.S. government agency TIPS that were issued back in 1997. Ten-year bonds of issuers such as Fannie Mae and the Tennessee Valley Authority pay 40 to 50 basis points more than TIPS, though they're less liquid.

--John Dizard