New Bond Products Aim to Reduce Inflation Risk

Several decades after the first bond mutual funds debuted, the training wheels have finally arrived.

Pimco Funds in Newport Beach has unveiled a bond portfolio that aims to protect shareholders from purchasing-power risk by holding inflation-adjusted securities. The American Century/Benham family in Kansas City, Mo., is hoping to follow suit this month, pending a final green light from the Securities and Exchange Commission. Dreyfus Corp. in New York expects to unveil its own product later this year, and offerings from other firms are likely.

What these funds have in common is that they buy or plan to invest in bonds whose interest payments and principal values rise over time with inflation. That makes them different from conventional bonds, which pay the same amount of interest every six months and come due at the same price for which they originally sold.

When available, the American Century/Benham Inflation-Adjusted Treasury Fund and the Dreyfus Inflation-Adjusted Securities Fund plan to focus on U.S. Treasury IOUs with the inflation-adjustment feature, after the government’s initial sale of these investments in January.

The Pimco Real Return Bond Fund is already up and running. It takes a global slant, focusing primarily on the new Treasuries but including inflation-adjusted holdings from Canada and New Zealand. The foreign bonds protect against inflation in these other countries, which might not be a key concern for U.S. investors. However, bonds issued in other markets sometimes offer better values than their U.S. counterparts, says Pimco manager John Brynjolfsson.

For example, he says the Canadian bonds are paying “real,” or after-inflation, yields three-quarters of a percentage point higher than their U.S. rivals, and the New Zealand IOUs offer real yields 1.5 points higher.

Regardless of the geographic slant, these funds represent investment milestones. That’s because bonds with an inflation-adjustment feature are less risky than conventional IOUs. When such a bond matures years down the road, investors know they will receive enough cash to buy roughly the same number of groceries, widgets or whatever that they can today.

Conversely, the bonds’ interest and principal values could decline in a deflationary period. But that’s not likely--the U.S. has not had a single year of net deflation since 1954. At any rate, the Treasury guarantees a minimum value at maturity.

Although the mutual funds that buy inflation-adjusted bonds strive to deliver the same safeguards as the individual bonds, they can’t offer the same degree of certainty. That’s because mutual funds constantly accept money from new shareholders and use this cash to buy more bonds. Thus, a fund does not mature on a predictable date the way an individual IOU does.

“These funds try to provide an after-inflation return, but that’s not guaranteed,” says David Schroeder, manager of the Benham fund.

One further drawback for the funds involves management fees and other ongoing costs to run a portfolio. These outlays are expected to total 0.5% annually for the Benham fund--equal to $50 a year for each $10,000 investment--and a bit more for the Pimco fund. Pimco also levies a maximum 3% sales charge on purchases, in contrast to the no-commission route available through Benham. Details on Dreyfus’ product were not available.

So why buy a fund rather than an individual inflation-adjusted bond?

Liquidity would be one reason. If you had to sell an individual Treasury before maturity, you would face trading costs, mainly in the form of a dealer “bid-asked” spread. On mutual funds, investors typically encounter no costs to sell.

Also, mutual funds are better depositories for investing small amounts of cash every now and then. With individual Treasuries, you would need roughly $1,000 for each bond you wanted to buy. By contrast, the Benham and Pimco funds accept subsequent investments of just $100 after you meet the initial minimums of $2,500 and $1,000, respectively.

The funds also offer a more efficient, convenient way to reinvest income payments into additional shares, bolstering your return over time. And after the Treasury has issued inflation-adjusted bonds with varying due dates, as is planned, the funds will offer a blending of maturities and yields.

One important footnote for both the individual bonds and mutual funds is that neither eliminates interest rate risk. All bonds and bond portfolios drop in price when interest rates are rising. Such price declines are necessary to keep the yields on these investments competitive with new bonds coming to market at yields that reflect the higher rates. That is, bond prices move inversely to yields.

Because of interest rate risk, investors in inflation-adjusted Treasury bonds or the funds face the possibility of lower prices on their holdings if they must sell out before maturity.

However, Schroeder and Brynjolfsson agree that the prices of individual bonds, and the funds that hold them, should prove less volatile because of the inflation-adjusted feature. Both interest rates and inflation contribute to the price fluctuations of conventional bonds, so by removing the inflationary effect, you remove some of the volatility.

But as less risky vehicles, inflation-adjusted bonds and funds also can be expected to return less than conventional bond products over time.

“These are appropriate for long-term investors seeking inflation protection,” Schroeder says. “But if you’re mainly interested in income, there are better vehicles out there.”