Benefits and Management of Inflation-Protected Treasury Bonds

Lingane, Peter James
September 2008
Journal of Financial Planning;Sep2008, Vol. 21 Issue 9, p60
Academic Journal
Treasury bond funds vaulted to the top of the fixed-income category in 2007 and smartly outperformed the U.S. equity markets. Inflation-protected Treasury bond funds (TIPS) did even beter returning almost 12 percent for the year These returns reflect a decline in interest rates and, for TIPS, under-forecasted inflation. TIPS outperformed conventional Treasury bonds over the past decade due to underforecasted inflation and shrinkage of the anomalous yield premium, but that superior performance may not be sustained. Conventional Treasury bonds are likely to outperform TIPS in a declining inflation environment. TIPS had been expected to be less volatile than conventional Treasury bonds, but the record does not support this. Because the returns and volatilities of TIPS are likely to be comparable with those of conventional Treasury bonds over long periods, portfolios should generally contain substantial proportions of each. Individual TIPS are ideal for funding a future obligation in real terms and can play an important role in retirement funding. Trustees should appreciate that buying TIPS rather than conventional Treasury bonds will generally reduce income distributions. Individual TIPS provide a variable cash flow because the inflation adjustment is not paid until maturity or sale. A ladder manages this variation. Buying at the original auction eliminates tax amortization issues. Individuals should generally locate TIPS inside a pension or IRA for tax efficiency. This location also eliminates tax complications caused by amortization and inflation adjustments.


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