UK Premium Bonds are a good investment

What became of TIPS?

Inflation-protected bonds have existed since 1742. Funds that invest in this asset class are relatively new. Until 2003, inflation-linked bonds were generally little known to the broader classes of investors. The asset class revived in 2004 and 2005 and more and more new fund products were launched.

How do TIPS work?

In contrast to traditional bonds, the return on an inflation linked bond depends on the actual measured inflation. TIPS (Treasury Inflation Protected Securities) consist of two components, the real interest rate and the inflation allowance. The real interest rate is the nominal interest rate that classic bonds work with, adjusted for the proportion of inflation. The main task of TIPS managers is to correctly assess future price increases. An example: The nominal interest rate on a ten-year French government bond is 3.9 percent, the real interest rate is 1.9 percent. The so-called break-even return for the TIPS manager is 2 percent. It can be thought of as the rate of inflation expected by the market. If the manager expects higher inflation, he buys the paper.

9.1 billion euros in 43 funds

In 2004 alone, 15 new euro-inflation-linked bond funds came onto the market, and last year the number increased by a further seven funds. Private investors can now choose from a total of 43 corresponding products (32 in euros, 4 each global or in US dollars, 2 UK and 1 CHF), which together represent 9.13 billion euros in volume.

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Inflation protectors with bigger losses

Since last autumn, however, inflation-protected bond funds have clearly disappointed: While conventional euro bond funds (measured by the respective Lipper fund average) have lost 2.1 percent in value since September 1, 2005 due to rising interest rates, the losses of the successful inflation protectors totaled 3.6 percent . Things have been even worse since the beginning of the year: Euro government bond funds surrendered 1.7 percent of their value, inflation-linked funds 3.2 percent.

Higher duration as the main reason

The main reason for this development is the different duration, emphasize the experts. Duration is a key figure that indicates how much the total return on a bond changes when the interest rate on the market changes. "While the average duration of inflation-protected euro government bonds, as measured by the Barclays Index, is 9.5 years, government bonds have a significantly shorter remaining term of 6.2 years," explains Johann Pruckner, fund manager of ESPA Bond Euro-Real. Roughly calculated, inflation-protected euro government bonds lose almost 9.5 percent of their value when interest rates rise by one percent.

Because against rising interest rates - since the beginning of the year the yield on 10-year bonds has risen from 3.5 to 3.9 percent - even inflation-linked bonds do not offer any additional protection. "Except when the rising interest rates are triggered at the long end by increased inflation expectations, which was not the case this time," adds Pruckner.

"Volatility surprised everyone"

Because of the higher duration, inflation protectors naturally have a higher volatility: In the last five years the standard deviation of conventional euro bond funds was 1.6 percent, inflation-protected euro bond funds were 2.5 percent p.a. more volatile by half. Many experts, however, originally assumed a different situation: “The disparate theory actually said exactly the opposite. That actually surprised everyone, including us, ”admits Josef Falzberger, fund manager of Schoellerbank Realzins Plus.

Long investment horizon protects against losses

Investors shouldn't let themselves be unsettled by the losses of long-term bonds - and basically inflation-protected bonds are just that - the experts emphasize. “The investment horizon, we recommend around eight years due to the remaining term, should, however, be adhered to. Because if you hold bonds to maturity, you will not be affected by price fluctuations, ”advises Falzberger. Erste-Sparinvest recommends that investors stay invested for at least five years. “Then you don't have to get nervous,” says Pruckner. Because in no five-year period did you achieve a lower return with bonds than with money market papers. "For this reason, a yield estimate of around four percent p.a. over this period seems realistic to us," Pruckner finally predicts.

The best funds at a glance

Investors who want to invest in inflation-protected euro bonds are currently offered 32 fund products to choose from. The top 3 based on the risk-adjusted return (Sharpe ratio p.a.) for the past three years come from AXA (0.67), KBC and Schoellerbank (0.54 each) - see also table above.

All data as of April 6, 2006 in euros

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