PREMIUM SEARCH Search by job title, geography and build a list of executive contacts
Even with what looks like good news about the consumer-price index, bond-market mavens are worried that we're sitting on an inflation powder keg, with energy prices likely to light the fuse. What can you do to protect your investments should inflation rear its head? Inflation-indexed bonds are one option. And a small, very interesting play would be those issued by the Tennessee Valley Authority. Yes, they're quirky. But they're also worth a serious look.
Created as part of President Franklin Roosevelt's New Deal, the TVA is an electrical-power wholesaler that's 100%-owned by the U.S. government. The TVA's inflation-indexed bonds, dubbed VIPS (Valley inflation-protected securities) by the bond-trading universe, are somewhat scarce. Only one relatively small sale of the bonds was made to the public. But locating them could be well worth the effort. They're virtually risk-free and offer high returns and an inflation hedge, says David Kotok of Cumberland Advisors Inc., an investment advisory firm that's a subsidiary of BankAltlantic Corp.
What has bond traders particularly excited is that VIPS are currently yielding half to nearly three-quarters of a percentage point (65 to 70 basis points) more than the initial U.S. Treasury inflation-protected securities (TIPS) that were issued a few months before VIPS. While TVA isn't the U.S. Treasury, it's the next best thing -- a government-created agency like Fannie Mae or Freddie Mac that has the implied backing of the Treasury. The government doesn't officially back the bonds, but experts say it would be highly unlikely that Washington would ever let a bond issue from one of these agencies fail.
GOOD NEWS. Here's how inflation-indexed bonds work. Typical Treasury bonds are sold at a set interest rate, known as the coupon, and that rate is your basic return. The return rate also rises or falls based on market demand for the bonds. Inflation-indexed bonds go one better and multiply the underlying value of the bond by the inflation rate. If inflation were 3%, the interest you would receive on a $100 bond would be the coupon rate times $103. Even better, the principal value of the bond accrues at the same rate of inflation. If the bond matured at the end of one year, you would receive $103 in principal -- not $100. So your ultimate rate of return is composed of interest plus capital appreciation.
Inflation is good news with these bonds. The higher the inflation rate, the faster the capital appreciation of the bond's value. If inflation slows, the value would accrue more slowly. If there were deflation, a highly unlikely scenario in the foreseeable future, the principal would decrease, but it would never drop below a preset level.
Issued as a 10-year bond back in 1997, VIPS mature on Jan. 15, 2007. They're noncallable and have a 3 3/8% coupon. But the current yield, based on the bond's value in the market, is around 4.65%. Add to that an inflation-adjustment factor of 3.6% to 3.7% (based on the annual increase in the CPI, the government's broadest gauge of inflation), and you're getting roughly an 8.3% return for virtually no risk. Not bad, considering that risk-free 30-year U.S. Treasury bonds are currently yielding just under 6%.
TRICKLE-DOWN EFFECT. If you're an optimist, you may think the risk of inflation is receding, and inflation-indexed bonds are an anachronism. It's true that the latest CPI, seasonally adjusted, show a 0.1% decrease for August. That means the cost of goods and services widely used by consumers went down slightly and, in theory, inflation was nonexistent. Following the report, many on Wall Street relaxed, concluding that the Federal Reserve now has no cause to raise interest rates.
It may be a bit too soon declare inflation dead. Back out the sudden drop in retail gas prices in August, and the CPI rose 0.2%. With the world's oil-production capacity closing in on 100% utilization, nobody expects gas prices to stay down. Bond mavens are worried that a sustained rise in oil prices would trickle through to the core components of the CPI. That'll happen when companies that produce goods and provide services -- such as transportation, new cars and trucks, medical care, leisure activities, and housing -- increase their prices to cover higher energy costs.
The bond market is taking this threat seriously. "At this point, with energy prices on the rise, with the risk of inflation increasing, we think some protection against inflation might be a good strategy for individual investors," says Jack Malvey, chief bond strategist at Lehman Brothers. This kind of thinking starts to make VIPS look very attractive.
"TATTOOS." But with only $300 million worth of these bonds trading in the open market, VIPS are nearly as rare as Pikachu cards. "The biggest factor in the way these bonds trade is availability," says John Brynjolfsson, executive vice-president at California fund manager PIMCO. "It's a unique issue that's impossible to recreate."
Of course, some bond traders say that VIPS' scarcity is a liability. "There is poor liquidity in these bonds," says Mike Ryan, fixed-income senior strategist at PaineWebber. "I view U.S. inflation-indexed notes as tattoos. You'd better like the way they look, because it's going to be really painful to get rid of them."
In addition, inflation-indexed bonds can have some hefty capital-gains tax levied against them, Ryan points out. Of course, that makes them a prime investment candidate for tax-deferred vehicles like 401(k)s or Roth IRAs. Ryan concedes for investors who don't have complicated tax issues, "they're a good buy and hold."
Even if investors hang onto these bonds until they mature, fund managers generally think VIPS are a great investment. "Every so often, Mr. or Ms. Market gives us a little inefficiency we can take advantage of," Kotok says. Investors take note: Market inefficiencies are always investment opportunities. And this particular one provides an inflation hedge that's especially appealing in the current economic environment.
Popper covers financial markets for BW Online in New York Edited by Beth Belton
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
Printer-Friendly Version
