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July 27, 2012, 12:02 a.m. EDT

Inflation fears boost TIPS funds

Inflation is low, but demand for protection grows

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By Deborah Levine, MarketWatch

NEW YORK (MarketWatch) — Investors are seeking protection from inflation in the bond market even as worries about a global growth slowdown or possible recession dominate trading, putting pressure on central banks including the Federal Reserve to add more economic stimulus.

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Investors have increased holdings of inflation-protected bond funds every month this year so far, while stock funds have seen an exodus every month since February, according to EPFR Global.

Buyers are focused on the U.S. government’s Treasury Inflation Protected Securities despite the debt carrying negative yields. In other words, they are willing to forego interest payments beyond keeping up with an expected, modest rise in inflation.

And investors are pursuing this strategy as the Fed, ahead of a meeting next week, mulls options to stimulate economic growth and the European Central Bank looks at other measures to tackle the euro zone’s debt and banking crisis. Read more: U.S. stocks leap on ECB’s euro reassurance.

Due to this demand, overall returns from TIPS are ahead of other major bond categories, including global debt and medium-term U.S. government bonds and other inflation hedges, such as gold.

Central bankers’ nontraditional policy steps create “the greatest monetary experiment in the history of mankind and we don’t know how it’s going to play out,” said Robert Gahagan, senior portfolio manager at American Century Investments. “That’s one factor keeping interest in TIPS right now.”

Mutual funds in the inflation-indexed category have returned 5% this year, according to investment researcher Morningstar Inc. That’s better than 3.7% in world bond funds and 2.7% for intermediate-term government bonds.

A proxy for inflation-protected bonds, iShares Barclays TIPS Bond ETF /zigman2/quotes/200600110/composite TIP +0.20% , has returned 5.5% so far in 2012.

TIPS — a $798 billion market — pay investors a coupon plus the rate of inflation over the life of the debt, derived from the Labor Department’s consumer price index.

The coupon is smaller than on regular Treasury notes because investors have a chance to get paid more as inflation rises. The gap between the yield on regular Treasurys and similar-maturity TIPS reflects investors’ expected inflation rate over the life of the bond. It’s known as the breakeven rate; if you matched the actual inflation rate, you’d break even whether you bought regular Treasurys or TIPS.

Long-term unknowns

With regular Treasury yields so low, the coupon portion of TIPS is negative. A negative yield might suggest investors are panicking about inflation. But the breakeven rate has stayed within a normal range of 2% and 3%, indicating inflation worries are neither disappearing nor exploding.

One reason for the discrepancy between inflation protection and slowing inflation in the last few months is that investors may be looking over a longer time horizon such as five to 10 years, said Gemma Wright-Casparius, co-manager of the $16.3 billion Vanguard Inflation-Protected Securities Fund /zigman2/quotes/207983017/realtime VIPSX +0.14%  .

“Breakevens don’t seem to be pricing in a disinflationary environment, but a slow and steady inflation of around 2%,” she said. “I don’t see concerns of disinflation or deflation in the market.”

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