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What are the downsides of TIPS?

I know treasury inflation protected securities pay a set amount and that you are protected from inflation, but beyond tax concerns, what else should I know about TIPS?

Feb 13, 2012 by Yasir from Yonkers, NY in  |  Flag
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Well, if inflation is realtively non-existent, so then is the total yield. The principal of your TIP bond is adjsuted for inflation, and then the interest is paid on the principal as adjsuted. The actual payout over inflation can be relatively low (the most recent TIP auction in January for 5 year TIPS had a interest payout of under 1%). Also, if you need liquidity, the principal value of your bond can decrease if newer interest payouts are higher. It gets harder to sell your remaining bond term on the open market, so you have to "discount" your bond to sell it. This is especially true in longer term bonds.

So if you only need your assets to keep pace with inflation, that can be a very good investment, but most folks need their assets to outpace inflation to ensure that they have enough to live on for their life expectancy. If uncertain, I would recommend working with a good advisor to inform you if a minimal yield over inflation would help you meet all your goals.

Comment   |  Flag   |  Feb 13, 2012 from East Dundee, IL

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David Fabian Level 19

One of the potential downside of TIPs is that they are still susceptible to interest rate risk in the event that we start to see the Federal Reserve moving up the Fed Funds rate in the next several years. These investments have enjoyed a remarkable run in price appreciation (along with several other areas of the bond market) over the last few years, but most TIPs are intermediate to long duration which make them more susceptible to price volatility.

The premium that you pay for a TIP vs. a regular treasury bond for the inflation protection component is steep in today's economic environment. You still need to consider having a strategy in place to manage the risk of rising interest rates for your fixed-income holdings. I would consider working with a portfolio manager or investment adviser that specializes in actively managing credit quality, duration, and asset allocation in the bond market to manage these risks.

1 Comment   |  Flag   |  Apr 22, 2013 from Irvine, CA
David P. White

Great answer David! (Must be something about the first name.) My firm’s Investment Committee believes the perceived prospects for future higher interest rates and higher levels of inflation have caused the market to bid the prices of TIP’s up to the level where there are better opportunities in conventional fixed-coupon bonds. As an alternative to TIP’s, investors can manage the duration and credit quality of a bond portfolio to assist in mitigating the negative effects of rising interest rates.

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Flag |  Sep 10, 2013 near San Diego, CA

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In a deflationary environment or an environment with low/flat inflation - with rising rates TIPs and funds that invest in TIPs suffer. TIPs do provide some protection vs. inflation and may have a place in a well-diversified portfolio. TIPs have been hit hard by the recent rise in interest rates.

Comment   |  Flag   |  Aug 01, 2013 from Cranford, NJ

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A nuanced but important detail is separating real yields from nominal yields. Nominal includes both real and inflation and is the fixed rate earned on regular bonds. Real yields are what you earn on TIPS PLUS the fluctuating inflation component. Until recently real yields on TIPS were negative due in part to quantitative easing causing additional price risk due to future rising real yields. Rising nominal rates due to expected inflation alone is not harmful to TIPS. Longer dated TIPS now trade with a solid positive real yield and even the 5-year is now starting to trickle over 0%.

Comment   |  Flag   |  Sep 10, 2013 from Western Springs, IL

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The real downside to TIPS is not very different from regular bonds, in that they also have Duration Risk or Interest Rate Risk. As interest rates rise, the principal falls in value. The longer the Duration of the TIPS, higher the risk of a decline in principal value. Moreover, this risk gets amplified when TIPS are yielding zero or have a negative yield. This is what has happened in 2013 YTD. While they do have an Inflation Indexed component, they also have a Duration component.

Comment   |  Flag   |  Oct 08, 2013 from Appleton, WI

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In addition to the good information above you have to consider who you are relying on to accurately compute inflation....in this case, the government. Our actual level of inflation will be quite different than the measure used by them, given they exclude several significant areas that you and I buy in their calculation (food and energy related items). So I would argue their definition of inflation will be less than the rate of inflation you actually experience over time. 2013 is a classic example of this. You hear the Federal Reserve lament the lack of inflation while you are likely paying more for food (or the same for smaller packaging), energy, insurance, tuition, etc. If you want a good explanation of why TIPS can be inefficient vehicles, search for Jeff Gundelach's (Doubleline Funds) recent discussion on TIPS.

The falling rate environment we have experienced for a long-time made TIPS (and most bonds) pretty attractive instruments. No one has a crystal ball to tell you where interest rates are heading, but I think the argument that they are headed higher is a lot easier to make than the alternative. If that is true, then bonds in general will have the wind in their face for the first time in a very, very long time. That doesn't mean you shouldn't own them, but it does likely mean that they no longer are going to "act" as risk-free instruments and that you should really understand what you own and why.

Comment   |  Flag   |  Nov 05, 2013 from Knoxville, TN

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I'm in agreement with many of the other experts who offered answers. TIPs tend to have relatively long maturities, so if interest rates rise, the value of your TIP investment may decline. For example, as of 11/4/2013 (per the iShares website), the iShares TIP ETF has a weighted average maturity of 8.51 years and a real yield duration of 7.73. Suppose real interest rates rise 1%, the value of that particular TIP ETF would be expected to decline by approximately 7-8%.

TIPS can be a very effective investment, but you generally want to have a reasonable degree of confidence that interest rates are headed lower. Given the current low level of interest rates compared with historical norms, rates may be more likely to rise over the long term than decline. Of course, there are always surprises in the bond market and rates may remain at low levels longer than most would expect.

Comment   |  Flag   |  Nov 05, 2013 from Deerfield, IL

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