The Case for Treasury Inflation Protected Securities Funds

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1 The Case for Treasury Inflation Protected Securities Funds A white paper from HARTFORD INVESTMENT MANAGEMENT COMPANY Introduction

2 Page 2 of 2 Diversification is a sound investment strategy in any economic environment, especially when there is a great deal of volatility in the financial markets. Treasury Inflation Protected Securities (TIPS) are a good addition to investor portfolios for those concerned about protection from inflation and diversification. As with any investment, one needs to understand the mechanics of Treasury Inflation Protected Securities before appreciating their benefits. This white paper will provide an introduction to the TIPS market, explain how TIPS work and establish why investing in a TIPS fund can add value to an investor s portfolio. I. Overview of Treasury Inflation Protected Securities Treasury Inflation Protected Securities are U.S. Treasury notes and bonds that have a fixed coupon rate and mature on a fixed date. The appeal of TIPS lies in the fact that their interest payout and principal are adjusted for inflation based on the monthly, non-seasonally adjusted Consumer Price Index ( inflation will be used to refer to this index). It is this characteristic that makes TIPS the best choice an investor has in terms of inflation protection. The unique performance of TIPS also can improve the overall risk-versus-return profile of a portfolio. TIPS were first issued by the U.S. government in January The Treasury department has issued five-, 10- and 30- year TIPS as part of its program. The TIPS market has grown to over $147 billion, or 4% of the total outstanding Treasury debt as of December (The Bureau of the Public Debt, 12/31/02) At the end of December 2002, a 10-year TIPS issue scheduled to mature in July 2012 yielded 2.262%, while a conventional 10-year Treasury maturing in August 2012 yielded 3.802%. This means that if an investor believes that inflation will exceed 1.54% annually over the next 10 years (the difference between the Treasury yield and TIPS yield), they should invest in TIPS. Investors have been diligently adding TIPS to their investment portfolios as the advantages of investing in this relatively new asset class has become more and more apparent. The increased popularity of TIPS is especially noticeable in examining cash flows into TIPS funds. For the 11 month period ending November 30, 2002, investors poured over $5.7 billion into TIPS mutual funds. To fully appreciate the advantages of adding Treasury Inflation Protected Securities to one s portfolio, investors should have a clear understanding of two concepts: 1) The impact inflation has on an individual s purchasing power 2) The difference between real and nominal yield 1) What is Inflation? Defined as a rising price environment, inflation can erode consumers purchasing power by making goods more costly. In the U.S., a key economic bellwether for tracking inflation (an increase in the price of goods and services) is the Consumer Price Index, which is published monthly by the Bureau of Labor Statistics. A study of inflation over time shows that since the end of World War II, prices have risen steadily in the U.S. For example, $1 in the beginning of 1947 is only worth $0.13 today. Inflation shrinks the value of your money so that a dollar today is worth less tomorrow. Inflation can be caused by numerous factors but the most common is when demand outpaces supply. Inflation poses a serious threat particularly for retirees and investors in fixed income because it can eat away at your investment returns. 2) Real yield versus nominal yield Although in fixed income, investors typically assess their portfolios nominal yield as a measure of what they will receive, a better indicator of changes in purchasing power would be to assess their portfolios real yield. The first step in understanding the impact of inflation is to recognize the difference between nominal and real yields. Nominal yield is the yield on investment before taking into account inflation. Real yield is the yield on investment after taking into account the impact of inflation, in other words, nominal yield minus inflation equals real yield. Nominal yield Inflation = Real yield

3 Page 3 of 3 For example, if an investor has a bond that has a coupon that pays 6% in interest and inflation is, the nominal yield and the real yield are both 6%. If the yield is 6% and inflation is 3%, the nominal yield remains 6% but the real yield is only 3% after inflation. When comparing nominal and real yield, it s important to remember what you see is not necessarily what you get. Investors who also focus on their portfolios' real returns are better able to protect their purchasing power. One asset class that investors may want to consider when targeting real returns is Treasury Inflation Protected Securities. Real returns can remain flat even as nominal returns climb due to rising inflation. An example of this (Exhibit A) occurred during the late 1970 s and early 1980 s when investors in the stock market experienced tremendous gains in the value of their equity holdings (Nominal), however, after the impact of inflation, real return on equity (Real) was flat. Exhibit A S&P 500 Total Return Index 1 Source: Bloomberg, January 1970 = 1 II. How Do Treasury Inflation Protected Securities Work? Treasury Inflation Protected Securities promise to compensate investors for the effects of inflation. They are unrivaled in terms of their ability to protect investors from the risk that inflation could erode the purchasing power of their assets. The principal on TIPS is adjusted for inflation, so the return to investors includes the stated yield plus the inflation adjustment. TIPS achieve that by first, adjusting the principal amount corresponding with changes in inflation. Then, the fixed coupon/interest rate is applied to the adjusted principal amount so that the interest payment is also adjusted for inflation. Investors receive an inflation-protected rate of return in the form of: 1) the semi-annual cash interest payments based on inflation-adjusted principal balances, plus 2) the greater of original principal or inflation-adjusted principal payable at maturity. Exhibit B Example of a $1,000 Inflation-Protected Bond with a 3.5% Coupon Rate* Year Beginning Principal Change in Inflation Adjustment to Principal Ending Principal Coupon Rate Coupon Payment 1 $1, % $22.00 $1, % $ $1, $0.00 $1, % $ $1, % -$4.09 $1, % $35.63 *This simplified table assumes annual coupon payments and does not reflect the change in market value of the bond; bond prices will change in response to market activity and may vary from principal value. 1 The S&P 500 index is unmanaged and does not represent the performance of any particular investment. It is comprised of the 500 largest companies in the United States. The S&P 500 Index is not available for direct investment.

4 Page 4 of 4 So if inflation rises 2.2% over the course of one year (Exhibit B), for example, a TIPS bond principal value would be expected to go from $1,000 to $1,022. That process continues so the final principal value of a TIPS bond will actually be unknown until maturity. Deflation can also decrease principal value, but it will never be less than the original principal at maturity. This chart is for illustrative purposes only. Assumes a TIPS with 3.5% annual coupon, 4% annual rate of inflation. Take the case of an investor who purchases a $10, year Treasury note with a stated 5% annual coupon interest payment. That investor will receive $500 annually for 10 years and the original $10,000 back at maturity for a total of $15,000. However, if inflation is 4% annually over the 10-year period, its presence (rate of inflation) will erode the purchasing power of that $15,000 (Exhibit C). In the case of TIPS, both the principal and interest payments increase to reflect any rise in inflation. In simple terms, if inflation is 4% per year on a $10, year TIP bond with a 3.5% annual coupon, the principal would have been adjusted upward to $14,802 at the end of 10 years and the interest payment made in the tenth year would be 3.5% of the inflation-adjusted principal, or $518 instead of $350 (calculated based on the original principal). The total value of the TIP bond at the end of 10 years is $19,172. The additional $4,172 above the 10-year Treasury note ($19,172-$15,000) is a result of the inflation adjustments accrued every year, thus making it possible for the TIPS note to keep pace with the rate of inflation. Exhibit C Comparison of a $10, year Treasury Note and Inflation Protected Bond - Assumes 4% Inflation Beginning Total Value at Coupon Principal Maturity After year 1 After year 10 Treasury $10,000 $15,000 $500 $500 TIPS $10,000 $19,172 $364 $518 In summary, when inflation is positive, both the interest payments and principal will be adjusted upward. If inflation falls, the principal would be reduced accordingly thus decreasing the semi-annual interest payments. The federal government continues, however, to guarantee to return at least the original principal at the time of issuance to the investor at maturity. III. The Case for TIPS! A Better Mousetrap? Historically, to hedge against inflation, assets like precious metals, real estate, commodities and equities have been the investment of choice. However, since Treasury Inflation Protected Securities are directly linked to inflation, they are very effective at protecting against inflation than asset classes traditionally used.

5 Page 5 of 5 The intrinsic nature of how the US government set up Treasury Inflation Protected Securities to behave, its principal accruing with inflation and its corresponding coupon adjusting with the inflation-adjusted principal amount, further reinforces the asset class effectiveness as a hedge against inflation. Although over long time periods, precious metals, real estate, commodities and equities may protect investors from the erosion of purchasing power caused by inflation, potential short term volatility may make these choices less desirable than Treasury Inflation Protected Securities, which are directly linked to inflation.! Added Benefit of Diversification Treasury Inflation Protected Securities, as a distinct asset class, have had low, even negative, correlations with other asset classes, including equities (Exhibit D). Correlation measures the degree to which two variables are associated with the value for correlation ranging from +1.0 to 1.0. A negative correlation means that the variables move, to a degree, in the opposite manner or direction. The negative correlation of equities to inflation implies that equities are not an effective hedge against inflation. This historical pattern suggests that TIPS are very effective for the purpose of diversification. The diversifying nature of this asset class should be considered very attractive to any investor interested in protecting the value of their investments. In fact, studies have shown that the inclusion of TIPS in one s portfolio can decrease the volatility and may increase the potential for greater returns. Exhibit D A Case for Diversification (Comparison of asset classes to LB TIPS Index) % Correlation to TIPS 5-5 LB TIPS (1) LB Aggregate Bond (2) LB High Yield (3) -33% MSCI:EAFE Hedged (4) -4 S&P 500 (5) Source: Callan Associates, December 2002 Correlation relative to LB TIPS index using monthly returns (3/1/97 12/31/02) 1 The Lehman Brothers U.S. TIPS Index represents securities that protect against adverse inflation and provide a minimum level of real return. To be included in this index, bonds must have cash flows linked to an inflation index, be sovereign issues denominated in U.S. currency, and have more than one year to maturity. 2 The Lehman Brothers U.S. Aggregate Bond Index: Bonds are represented by the Lehman U.S. Aggregate Bond Index which is comprised of approximately 6,000 bonds including the U.S. government, mortgage-backed, corporate, and Yankee bonds with an average maturity of approximately 10 years. The Index is weighted by the market value of the bonds in the index. 3 The Lehman Brothers High Yield Corporate Bond Index is considered to be representative of the fixed rate, publicly issued, non-investment grade debt registered with the SEC. This unmanaged index includes publicly issued US Treasury obligations, debt obligations of US government agencies (excluding mortgage backed securities), and fixed-rate non-convertible investment-grade corporate debt securities. 4 The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. 5 The S&P 500 index is unmanaged and does not represent the performance of any particular investment. It is comprised of the 500 largest companies in the United States. The above indices are not available for direct investment. The above indices past performance is not indicative of future results. Securities rated BB and below are commonly referred to as high yield, high risk securities or junk bonds. High yield bonds generally involve greater credit risk and may be more volatile than investment grade bonds. Investing in foreign issuers and non-dollar securities may involve different and additional risks associated with foreign currencies, investment disclosure, accounting, securities regulation, commissions taxes, political or social instability, war, or expropriation.

6 Page 6 of 6! Perform Well in Varying Market Environments Investors looking to grow their investment should be pleased with TIPS ability to deliver competitive returns under a variety of economic conditions. TIPS have generated competitive returns over the past three years, as illustrated in the chart below. Exhibit E 5 Solid Investment Performance Annualized Return % -0.77% -8.46% % 10.65% 10.09% 9.37% 12.49% NASDAQ (1) High Yield (2) DJIA (3) S&P 500 (4) U.S. Treasury (5) Corporate (6) Mortgages (7) U.S TIPS (8) Data Souce: Lehman Brothers, Dec Asset Class 3-Year Total Returns through 12/31/02 1 NASDAQ Composite Index measures all NASDAQ domestic and non-u.s. based common stocks listed on the NASDAQ stock market. 2 The Lehman Brothers High Yield Corporate Bond Index is considered to be representative of the fixed rate, publicly issued, non-investment grade debt registered with the SEC. This unmanaged index includes publicly issued US Treasury obligations, debt obligations of US government agencies (excluding mortgage backed securities), and fixed-rate non-convertible investment-grade corporate debt securities. 3 Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded blue-chip stocks, primarily industrials. You cannot invest directly in the DJIA. Illustration is price only and assumes no transaction cost. 4 The S&P 500 index is unmanaged and does not represent the performance of any particular investment. It is comprised of the 500 largest companies in the United States. 5 Lehman Brothers U.S. Treasury Index is comprised of public obligations of the U.S. Treasury with a remaining maturity of one year or more. 6 Lehman Brothers U.S. Credit Index is comprised of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. 7 Lehman Brothers Mortgage Backed Security Fixed Rate Index covers the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is formed by grouping the universe of over 600,000 individual fixed rate MBS pools into approximately 3,500 generic aggregates. 8 The Lehman Brothers U.S. TIPS Index represents securities that protect against adverse inflation and provide a minimum level of real return. To be included in this index, bonds must have cash flows linked to an inflation index, be sovereign issues denominated in U.S. currency, and have more than one year to maturity. The above indices are not available for direct investment. Securities rated BB and below are commonly referred to as high yield, high risk securities or junk bonds. High yield bonds generally involve greater credit risk and may be more volatile than investment grade bonds.

7 Page 7 of 7 Over the brief existence of the TIPS market (since 1997) we have been able to measure performance in both rising and declining interest rate environments. TIPS outperformed comparable Treasury securities by a significant margin in the rising rate environment experienced in 1999 (Exhibit F). More surprising is that TIPS also outperformed comparable Treasury securities in the declining rate environment experienced in 2001 (Exhibit G). Exhibit F 10-year TIPS vs. 10-year US Treasury Performance in Rising Rate Environment of % 4% 3.31% 2.56% 2% Total Return -2% TIPS outperformed -4% by greater than -6% 970 basis points -8% -6.42% TIPS Source: Lehman US Treasury Inflation TIPS: US Treasury Note /15/2008 Nominal: US Treasury Note /15/2008 Total return figures from Jan Dec 1999 In the case of a rising rate environment similar to the one we experienced in 1999, a representative TIPS bonds outperformed nominal bonds by over 970 basis points. Hypothetically, a TIPS bond maturing in 2008 yielded a total return of 3.31% while a comparable maturity, nominal US Treasury bond yielded a negative return of 6.42%. In addition to outperforming nominal bonds in terms of total return, TIPS bonds also exceeded the rate of inflation. Exhibit G In the case of a declining rate environment similar to the one we experienced in 2001, again TIPS bonds outperformed nominal bonds and the rate of inflation. Hypothetically, a TIPS bond maturing in 2010 yielded a total return of 7.22% while a comparable maturity, nominal US Treasury bond yielded a lesser return of 6.35%. With the rate of inflation increasing at a rate of 2.13%, the real total return on the nominal bond was 4.22% after one adjusts for the rate of inflation. 10-year TIPS vs. 10-year US Treasury Performance in Declining Rate Environment of 2001 Total Return 1 8% 6% 4% 2% 7.22% TIPS outperformed US Treasury bonds and Inflation 6.35% 2.13% TIPS US Treasury Inflation Source: Lehman TIPS: US Treasury Note /15/2010 Nominal: US Treasury Note /15/2010 Total return figures from Jan Dec 2001

8 IV. Risks Page 8 of 8 Despite their advantages, investors should understand that TIPS aren t absolutely risk-free. TIPS are subject to interest rate risk. Like all other bonds, they are not immune to the pressures of rising interest rates. However, because TIPS have better price protection through inflation adjustments, they tend to perform well in a rising rate environment if rates increase due to inflation. If interest rates were to rise and we saw a decline in inflation, it could create an environment where TIPS could underperform. Also, the index the Treasury uses when adjusting TIPS principal is the non-seasonally adjusted CPI-U, a measure that has shown historic month-to-month volatility. Based on the value of this index, yield distributions made by a Fund may increase or decrease on a month-to-month basis. As with most investments, one needs to understand the tax picture before investing. Individual TIPS bonds are taxed similarly to zero coupon Treasury bonds. The inflation adjustment is taxable in the year it occurs even though the investor won t receive the additional principal until the bond matures. The investor is in effect responsible for paying taxes on income which they have yet to reap the benefits. This phenomenon which impacts direct buyers of TIPS is known as phantom income. (Within a mutual fund structure, phantom income is not problematic since as a TIPS fund shareholder, the original interest income and the income from principal adjustments are generally distributed monthly by the Fund.) V. Summary Investors perceive fixed income as a safe haven in the investment market. Steady coupon payments over the life of a bond attract conservative investors. High quality bonds such as those of the U.S. Treasury provide a comfort level for those looking for security from credit risk. There is a risk, however, that even the highest quality fixed rate bond portfolio cannot avoid, the risk of inflation. Investors concerned with the impact of inflation on their investments and the erosion of future purchasing power can insulate against inflation s threat by including TIPS as part of their investment strategy. TIPS are designed to protect against rising prices and like Treasury bonds are backed by the full faith and credit of the U.S. government. Investors have the government s assurance that they will always receive at least the original face value of the bond at maturity. The addition of Treasury Inflation Protected Securities to an investor s portfolio can have a positive impact on performance while reducing overall risk. TIPS have a low correlation with other types of asset classes which helps to potentially reduce overall portfolio volatility. TIPS add value to an investor s portfolio by safeguarding long-term purchasing power, providing a better hedge than traditional inflation hedges and providing superior diversification since TIPS perform well in varied market environments. The Hartford Mutual Funds are underwritten and distributed by Hartford Investment Financial Services, LLC. For more complete information on The Hartford Mutual Funds, including charges and expenses, obtain a prospectus from your Investment Representative, or call for information on mutual funds. Please read it carefully before you invest or send money.

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