Are ‘Inflation-Protected’ Bonds a Good Investment?
Uncle Sam’s plan to issue “inflation-protection” Treasury bonds, as announced Thursday, is aimed directly at individual investors. But whether you should bite is another matter.
Here are some questions and answers about the Treasury’s proposed bonds:
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Q: Isn’t inflation risk the most important consideration for bond owners?
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A: It’s certainly one of the most important. When you buy a bond, you’re essentially loaning money to the issuer (say, $1,000 to the Treasury) for a specific period of time, and at a set interest rate. But the purchasing power of that $1,000 will be lower when you get it back, reduced by whatever the inflation rate has been during the period.
So the Treasury’s idea is to guarantee compensation for that lost purchasing power.
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Q: Sounds great. What’s the catch?
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A: In financial markets, you rarely get something for nothing. If the Treasury is going to lower the inflation risk of holding a bond, that bond is likely to pay less interest upfront than regular Treasury bonds.
In other words, if a regular 10-year Treasury note pays an annual yield of 6.7%, an inflation-adjusted 10-year note might pay about half that yield, because of the inflation-protection feature.
Exactly how much the yields will differ isn’t clear, because the Treasury isn’t sure how it will structure the new bonds. But in any case, the Treasury has made it clear that one goal in issuing the new bonds is to reduce the government’s financing costs.
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Q: So I could conceivably earn less, over time, in an inflation-adjusted bond than in a regular bond?
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A: Yes. But you also could earn more. It all depends on the difference in yields between the two securities, and on what the inflation rate turns out to be over time.
Consider: Even if the annual yield on inflation-adjusted bonds is much lower than on regular bonds, if inflation rises sharply you would be compensated for it. Owners of regular Treasury bonds, on the other hand, would get no such compensation.
As an investor, you would have to make a judgment about the long-term trend of inflation, and compare the current yields on inflation-adjusted bonds with the yields on regular bonds, which already have an “inflation premium” built into their yields.
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Q: What does that mean--an “inflation premium”?
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A: Bond investors are already assuming a certain level of inflation, so they demand yields that will compensate them above that inflation rate. For example, the yield on 10-year Treasury notes is currently 6.7%. The inflation rate in recent years has been about 3% annually. If inflation stays at that level, a 6.7% yield produces a “real” return of 3.7 percentage points per year--a handsome return, historically, for bonds.
But if inflation were to zoom to 8% per year, the real return from a 6.7% yield would be a negative 1.3 percentage points. The owner of an inflation-protected bond, however, would be guaranteed a positive real return no matter what the inflation rate.
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Q: How would the Treasury guarantee that inflation protection?
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A: That’s still up in the air. The Treasury wants ideas from investors and from Wall Street. The Treasury could offer bonds whose interest rates adjust periodically, pegged to some inflation index (such as the consumer price index). Or it could issue the bonds at a set interest rate, like regular bonds, and pay investors at the bond’s maturity for the inflation penalty incurred over the years.
In other words, instead of getting back the $1,000 you paid for the bond, you might get back (after 10 years, or whatever the term is) a total of $1,200, or $1,300, or whatever amount compensates you for lost purchasing power.
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Q: It sounds like inflation-adjusted bonds will be pitched mostly to long-term investors.
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A: Exactly. The Treasury expects these securities to appeal to people saving for retirement, such as through 401(k) savings plans. Those investors might not be attracted to bonds now because of fear that inflation will rise in the long run, devaluing fixed-rate bonds. With inflation protection, there’s no reason to fear that kind of devaluation.
By the same token, if the inflation compensation is paid at the bond’s maturity, while the bond’s current yield is below yields on regular bonds, these securities may not appeal to investors who need high current income, such as retirees living off their savings.
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Q: All things considered, isn’t the guarantee of inflation protection pretty alluring?
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A: Perhaps. But experts note that your goal as an investor is to earn returns that significantly beat inflation, not just keep up with it.
The risk in buying inflation-protected bonds is that, if inflation stays subdued, you might be locking in a fairly low real rate of return relative to what you could earn on regular bonds.
What’s more, if inflation were to surge, your purchasing power would be preserved in the new bonds. But other securities--especially stocks--could produce returns well above those of inflation-protected bonds.
In fact, over long periods, stocks have historically produced the highest real returns of any major class of financial investments. That makes sense: You’re taking on more risk by investing in stocks, and economic law dictates that higher-risk investments must produce higher returns over time.
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