Inflation appears to be contained, but that hasn’t stopped inflation-protected-bond funds from outperforming.
PHILADELPHIA — Inflation appears to be contained, but that hasn’t stopped inflation-protected-bond funds from outperforming.
As of last Wednesday, they had an average year-to-date return of 3.48% — the best among all fixed-income categories, according to Morningstar Inc. of Chicago. That’s a big improvement over their average one-year return of 2.06% — the worst among all fixed-income categories.
That performance is surprising because of the subprime-mortgage meltdown. Market volatility has traditionally favored short-term, high-quality bonds.
Also, consumer prices, which had been surging earlier in the year, edged up just 0.1% last month, the smallest advance since prices were flat last November. Core inflation, which excludes volatile energy and food, was also well behaved, rising by just 0.2%, the same as in June.
But inflation-protected-bond funds and the bonds in which they primarily invest — Treasury inflation-protected securities — are still going strong.
TIPS are identical to Treasury bonds except that principal and coupon payments are adjusted to eliminate the effects of inflation.
For the 30-day period ended last Wednesday, inflation-protected-bond funds were up an average of 1.36%, behind only long government bond funds, which were up 2.12%, according to Morningstar.
Persistent skepticism
At least one financial adviser, however, isn’t convinced that TIPS or the funds that invest in them will continue to outperform.
TIPS should do well during periods of unexpected inflation and outperform U.S. Treasuries during those stretches of time, said Matthew Reznik, a wealth manager with Balasa Dinverno & Foltz LLC in Itasca, Ill.
“Since we do not anticipate higher inflation in the immediate future, as the [Federal Reserve] has been very diligent about controlling inflation through its monetary policy, TIPS should not be expected to outperform nominal Treasury bonds,” he said.
Other advisers aren’t sure what to expect.
It’s true that inflation doesn’t now appear to be much of an issue, said Don Martin, president of Mayflower Capital in Los Altos, Calif.
In fact, he said, recent market swings indicate a “deflationary panic.”
That means the price of TIPS could head south — a potential buying opportunity for the value-oriented investor, Mr. Martin said.
But that may not happen.
“If we have the appearance of deflationary panic like during the past two weeks, the counterintuitive possibility is that excessive Fed easing will cause inflation, thus hurting bonds, and the marketplace could anticipate this and immediately build that into the price of TIPS,” Mr. Martin said.
It’s an unusually confusing situation. “There are a tremendous amount of crosscurrents in the market right now, a tremendous amount of uncertainty,” said John Hendricks, a senior vice president with Hartford (Conn.) Investment Management Co., a unit of The Hartford Financial Services Group Inc. and a portfolio manager of the Hartford Inflation Plus Fund.
Much of the uncertainty is due to market participants that don’t yet know the extent of the subprime-mortgage meltdown, which has roiled credit markets, he said.
It’s possible that if the Fed is forced to ease “with inflation still at the upper end of the comfort zone,” that could lead to higher inflation, Mr. Hendricks said.
But other signs point to inflation’s being less of an issue in the short term, he said.
For example, there has been a “dramatic” pullback in gasoline and crude-oil prices, Mr. Hendricks said.
Long-term, however, the situation looks good for TIPS and
inflation-protected-bond funds, he said.
China and Asia as a whole continue to consume massive amounts of resources, adding to inflationary pressure, Mr. Hendricks said.
Another reason things look good: TIPS are still relatively cheap, said Don Ellenberger, a senior vice president with Federated Investors Inc. of Pittsburgh and portfolio manager of the Federated Real Return Bond Fund, an inflation-protected-bond fund launched in October.
“I don’t think it’s really that clear,” said Paul Herbert, an analyst with Morningstar, questioning the assumption that TIPS are cheap.
Performance guesswork
While it’s true that inflation-protected-bond funds have been the best-performing fixed-income category year-to-date, whether that continues is anyone’s guess, he said.
They got off to a good start this year because there was some inflation, and there was a flight to quality because of market volatility that benefited funds that invest in TIPS, Mr. Herbert said.
As a result, TIPS may no longer be cheap, he said.
But even if that results in inflation-protected-bond funds’ losing their position as the top-performing bond fund category, investors should still consider them and, in some cases, individual TIPS, Mr. Herbert said.
They can be a good hedge against inflation whenever it becomes an issue, he said.
Some financial advisers agree.
“In the past six months, we’ve made a big move to TIPS for clients,” said Sherman L. Doll, managing partner with Capital Performance Advisors LLP of Walnut Creek, Calif.
The move, however, wasn’t driven by a belief that inflation was an imminent threat, he said; it was driven by the belief that it could someday be a threat.
“We’re especially doing this for clients who’ve had good portfolio returns over the past five to six years and where we want to help them preserve their wealth,” Mr. Doll said.
