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Inflation-linked bonds give investors option

Bonds can be a horrible investment. But maybe they aren't quite as horrible as I thought.

This change of heart is prompted by the inflation-indexed Treasury bonds, first sold in January. The 10-year notes initially paid 3.45 percent. Interest rates have since fallen, but the bonds still yield more than 3 percent.

This 3 percent-plus yield is intriguing because it is a "real yield," which means this is the amount that investors will collect above any increase in inflation. If investors are pricing inflation-indexed bonds to yield over 3 percent, presumably they are looking for at least that much from conventional longer-term government bonds.

What is so intriguing about that? Contrast the inflation-indexed bonds' 3 percent-plus real yield with the return on longer-term government bonds since year's end 1925. According to Chicago researchers Ibbotson Associates, the real return on government bonds over this 71-year stretch was just 1.9 percent a year.

The difference between 1.9 percent and 3 percent, while seemingly small, has huge implications for folks who are saving for retirement or investing in retirement. Slight differences in return can mean an enormous difference in your long-run gain. At 1.9 percent a year, it takes 37 years to double your money. But at 3 percent a year, it takes only just over 23 years.

If bonds are capable of generating more than 3 percent a year after inflation, investors may be able to take less risk, by keeping less in stocks and more in bonds, and still amass their target retirement nest egg or generate their desired retirement income.

So are the inflation-indexed bonds a harbinger of better real returns from bond investing? The experts disagree.

"It's surprising to see the inflation-indexed bonds have that high a yield," Scott Lummer, Ibbotson managing director, says. "I wouldn't have predicted that. I think real yields will come down."

Lummer suspects the high initial yield reflects uncertainty about the new bonds. Because the bonds are little more than a month old, it is difficult to know how much their prices will gyrate and how easy they will be to trade.

In addition, investors may be worried about what would happen if Washington tinkers with the consumer price index. The principal value of the inflation-indexed bonds, and the interest they pay, gets stepped up along with increases in the CPI. However, the Treasury has said it will protect investors against fundamental changes in the CPI.

Despite the high initial yield on inflation-indexed bonds, Lummer figures that, over extended periods, long-term government-bond investors might earn real returns more like 2 percent a year after inflation. The history of market returns over the past 71 years is clearly on his side.

Forget history, retorts Peter Bernstein, a New York economic consultant. "The period from 1950 to 1980 distorts everything," he argues. "It was a catastrophe in the bond market. I think people have long had in their heads a real figure of 3 percent. But real returns were all over the place because people made very bad inflation forecasts."

Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School, thinks the postwar period was an aberration. "Now bondholders understand the inflationary process better and demand a real yield of over 3 percent," he says. "The yield looking forward is much better than the yield looking back."

Siegel points out that in the 19th century the real return on longer-term government bonds was 5.3 percent. But he also notes that real bond returns haven't been nearly as consistent as real stock returns.

"I believe the expected return (on bonds) is 3 percent or 3.5 percent," Siegel says. "But what the actual return turns out to be depends on inflation."

So who is right? Should we expect a real return of 2 percent or so from bonds or can we hope for more than 3 percent? I suspect real returns could, indeed, better 3 percent. But only time will tell.

This much is clear: If real bond returns going forward are 3 percent-plus, today's inflation-indexed bonds, with their guaranteed inflation protection and their 3 percent-plus yield, look like a decent investment. And if real bond returns come in closer to 2 percent, the new bonds are a bargain.

Tempted? American Century Investments started an inflation-indexed bond fund last month, while Dreyfus Corp. has plans for a similar fund.

But don't rule out individual bonds, which can be bought directly from the government through the Treasury Direct program. The next auction is slated for early April, with bonds sold in minimum denominations of $1,000.

For information, call the Federal Reserve Bank in Jacksonville at (904) 632-1179 or (904) 632-1190 between 9 a.m. and 2 p.m. weekdays.

_ Jonathan Clements writes for the Wall Street Journal.