Morningstar Advisor - Fall 2008 - 74

Bond Fix Top TIPS Picks Two TIPS funds are Morningstar Analyst Picks: Harbor Real Return Instl HARRX This fund invests most of its assets in TIPS, but sometimes it will head into other sectors. Vanguard Inflation-Protected Secs VIPSX This is just about the most plain-vanilla way to get mutual fund exposure to TIPS. payments over time. Moreover, for retirees and individuals unwilling to take on the volatility of stocks and commodities, TIPS offer a better mousetrap. First introduced by the U.S. government in 1997, TIPS are backed by the full faith and credit of the government, like nominal Treasuries, and designed to see principal and interest payments track inflation. It’s important for investors to understand that TIPS’ coupons do not change themselves; they are fixed. Instead, the underlying principal changes with inflation. A fixed interest rate on an expanded principal amount (assuming inflation is present in the CPI) will yield a higher (inflation-adjusted) interest payment than that of Treasuries. Unlike equities and commodities, TIPS provide an explicit inflation-hedging tool and deliver steady and predictable cash flows, given a particular rate of inflation. Beyond the security and inflation hedge that they offer, TIPS also can provide diversification. Funds in the inflation-protected bond category have offered a very high level of noncorrelation to equity markets, both domestic and foreign. This makes them a good addition to a well-diversified portfolio. TIPS, however, don’t seem to offer much diversification benefit away from the higher-quality domestic fixed-income categories. Over the past decade, for example, TIPS funds had a correlation of 0.82 with intermediate-term bond funds. Many market observers and managers we speak with argue that TIPS, as with nominal Treasuries, appear overvalued now, but the long-term case for including a modest stake in client portfolios is still a strong one. The benefits that these securities afford investors have certainly been on display during the credit crisis of the past year, where the sector has been one of the strongest performers in the fixed-income marketplace. K Contributing editor Lawrence Jones is an associate director of fund analysis with Morningstar. Wal-Mart Stores WMT are high-quality firms that exhibit sustainable competitive advantages over rivals. They hold dominant positions in their industries and have greater pricing power than competitors, putting them in a better position to pass on price increases to customers. These same characteristics also can aid the firms in difficult economic times; advantages they hold over rivals often result in strong balance sheets and diversified revenue streams, which can mitigate economic trouble. A fund that specializes in investing this type of company is Dreyfus Appreciation DGAGX. Another good way to guard against inflation risk is commodities. Commodities tend to display negative correlations to equity and bond returns but a positive correlation to inflation. Thus, a fund like PIMCO CommodityRealReturn PCRDX, which offers a derivatives-based strategy that attempts to modestly beat a benchmark that provides exposure to a wide range of commodities, can be an effective inflation-fighter. A True Inflation Hedge Free. Quarterly. Don’t miss an issue. Subscribe today! Call 888 235-0828 or visit MorningstarAdvisor.com Both equities and commodities, while important tools in achieving strong real returns, do not provide an explicit hedge against inflation as measured by the Consumer Price Index. For that, investors need Treasury Inflation Protection Securities (TIPS), the main weapon in the fixed-income investor’s tool kit for keeping inflation risk at bay. TIPS’ par values are adjusted in line with the CPI, providing principal protection and increased interest 74 Morningstar Advisor Fall 2008 Magazine Ad _ VR _ 8 July 2008 _ Final

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Morningstar Advisor - Fall 2008

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