Bonds to Beat the Investment Cycle


By Christopher Farrell The message from the latest policymaking meeting at the Federal Reserve Board: The central bank can't figure out what's going on. How weak is the economy? The Fed doesn't know. What will the impact of war in Iraq be on the home front? Your guess is as good as Greenspan & Co.'s. Are the forces of deflation gathering momentum, or is another bout of inflation in the cards? Flip a coin. So, just as confused as the rest of us are, the central bank decided to keep monetary policy unchanged for now.

Investors are buying stocks as the war with Iraq begins. The betting is that war will be short. Still, U.S. government bonds remain the investment of choice for the safety-conscious. So far during this troubled, tumultuous year, bonds have had a total return of 2% compared to a miserable negative total return of -5.5% for equities.

Still, this column has emphasized that bonds are risky investments at this juncture. Yes, bond-market values could remain relatively stable -- and maybe even rally a bit -- during the fighting. Yet with bond yields at generational lows, the era of double-digit returns that investors enjoyed until recently is likely over. Odds are interest rates will tick higher and bond prices fall once the cannons fall silent and business confidence rebounds.

VIRTUOUS AND VICIOUS. There's a time-honored rhythm to market performance: Investment success eventually sows the seed of its own demise. The dynamic is simple, although it can take years to play out. The word about good investment fortune spreads. More people join in. Prices are driven higher. More investors commit money.

The virtuous cycle turns vicious, however, as the overpopularity of an investment forces returns to shrink. Revulsion eventually sets in. Prices cascade lower. Returns falter. Investors flee. And so on. That's what happened to stocks during the boom and subsequent bust. It will also happen to bonds.

There is an exception. One fixed-income security should remain on many investors' buy list in times good and bad: Inflation-protected bonds. The depreciation of the currency is a fixed-income investor's nightmare. Even if inflation averages a low annual rate of 2% to 3% over the next quarter century -- well into the retirement age of the average baby boomer -- that's still enough to depreciate the value of a dollar by nearly half.

Inflation-protected securities hedge against the erosion of inflation. It's one way to guarantee that a dollar saved today while working in your 40s will be still worth a dollar when you retire in your 60s.

ONE DRAWBACK. The federal government offers investors two securities specifically designed to eliminate the risk of inflation. One is the Treasury Inflation Indexed Security, better known as TIPS. Like all Treasuries, these securities pay a constant coupon or interest rate. But the bond's principal value is adjusted to changes in inflation as measured by the consumer price index.

TIPS are offered in 10-year maturities these days. One drawback to these bonds is that investors are required to pay taxes on their inflation-adjusted gains before they get their inflation-adjusted money at maturity. TIPS work best in a tax-deferred retirement savings accounts.

For many individual investors the government's other inflation-protected bond is more appealing: The I-bond. It's a savings bond, and it shares many of the same attractive investment features as its better-known cousin, the traditional Series EE savings bond. No commission costs are imposed when buying or selling I-bonds. They're sold at face value (up to $30,000 a year) and earn interest for 30 years, although you can sell after five years with no penalties. The investment compounds tax-deferred until the bonds are cashed in.

PRESERVING WEALTH. Like TIPS, I-bond interest rates have two components. The current I-bond earns a fixed rate set for the life of the bond of 1.60%. It also has a consumer price index semiannual inflation adjustment, now at 1.23%. I-bonds bought before April will earn 4.08%. The rate adjusts every six months. (You can get much more detail about I-bonds at www.savingsbonds.gov.)

You won't get rich overnight on I-bonds. But that's not the idea. I-bonds are a valuable tool for preserving wealth over the long haul. And as the past couple of years have taught, saving for retirement is less about making lots of money and more about minimizing downside risk -- especially in perilous times like these. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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