One Good Idea: Buy TIPS

These bullet-proof bonds safeguard principal, and even inflation cannot dent them

By Dianne Maley
Globe Investor Magazine online, November 17, 2008

Source: Michael Hart, head bond trader at Friedberg Mercantile Group Ltd.

The idea: Buy U.S. Treasury inflation-protected bonds, known as TIPS.

"The only thing I would suggest for people right now is safety," Mr. Hart says. "If you want something bullet-proof with nice upside, buy U.S. TIPS."

The fear of looming deflation sparked by the global credit crunch has led investors to dump TIPS in favour of regular Treasury bonds, beating down their price in relative terms. For example, iShares Lehman TIPS, an exchange-traded fund traded in the United States, has tumbled from a high of about $107 (U.S.) in August to a low of nearly $92 in October. It has since crept back to the $95 range.

"We've had a nice pullback in price of these bonds," Mr. Hart said in an interview. "For somebody on a fixed income who wants potential upside, it's a wonderful play."

TIPS now yield 2.88 per cent plus the inflation rate, which was 2.6 per cent in September - a total of 5.48 per cent.

Mr. Hart thinks inflation is the more enduring danger, given the pace at which the U.S. Federal Reserve Board is flooding the market with money.

"They're printing money en masse right now," he says. Economic theory holds that sooner or later, that will ignite inflation. The Payoff: The beauty of TIPS is that both your principal and interest payments are pegged to inflation, making them a great tool for investors wanting an indexed pension. Interest is paid semi-annually, and the principal is adjusted according to the latest consumer price index. This gives you a "free call" on inflation, Mr. Hart notes.

"If inflation takes off, you'll do very well with these bonds." Even if inflation holds steady, the bonds are still attractive, he says.

Investors who would prefer to keep their investment in Canadian dollars can buy the Canadian equivalent, real return bonds issued by the Government of Canada, also pegged to the inflation rate.

As with any interest-bearing security, it is best to hold TIPS in an RRSP because the interest payments and inflation adjustment are taxed at marginal tax rates.

The Big Risk: A sudden surge in real interest rates (after subtracting inflation) could knock down TIPS' value in the marketplace, Mr. Hart cautions. Interest rates and bond prices move in opposite directions. Still, TIPS prices are less volatile than long-term bonds that are not inflation-protected.

You could also lose if deflation takes hold, an event Mr. Hart considers unlikely. With deflation, the principal would be adjusted downward, so interest payments would fall. Still, TIPS have a safeguard against deflation because if the principal is lower than the original amount when they mature, you get back the full face value.

Why listen to Michael Hart?

Mr. Hart's 23 years of experience on Friedberg's bond desk under the mentorship of super-trader Al Friedberg have given him a keen eye for both risk and opportunity. Mr. Friedberg manages the Friedberg Global Macro Hedge Fund Ltd. The fund's year-to-date return as of Oct. 31 was 28.37 per cent.

Special to The Globe and Mail