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Are there benefits to investing in an ETF or mutual fund that invests in TIPS?

Feb 17, 2012 by Phyllis from Eugene, OR in  |  Flag
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The main benefit of TIPS is inflation protection. If you believe that inflation is likely to be a risk in the future, then TIPS could make sense for you as they have been designed to perform better than traditional fixed income securities. Personally, I advise my clients to avoid TIPS for the following reasons: (1) I believe there are better inflation hedges than TIPS; (2) TIPS are, at the end of the day, fixed income securities, and the fixed income risk component will likely perform poorly in an inflationary environment (bonds lose value as rates go up). If inflationary expectations run ahead of actual inflation, then TIPS could actually lose value in the early stage of an inflationary cycle. (3) In the current climate, interest rates and inflation are both low, which means TIPS have little performance upside unless inflation rises substantially and rates stay low, an unlikely scenario in my opinion.

View all 4 Comments   |  Flag   |  Feb 17, 2012 from San Francisco, CA
Jeffrey Allen Bogart

Isn't that just crazy James, I've been avoiding long-term fixed income like the plague. Short term markets are just plain wacky!

Flag |  Feb 17, 2012 near Cleveland, OH
James P. Dowd, CFA

..which reminds me of one of my favorite investment aphorisms: the market's ability to remain irrational is greater than your ability to remain solvent.

Flag |  Feb 17, 2012 near San Francisco, CA

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A TIPS is a US Treasury security with its principal linked to the Consumer Price Index (CPI) measure of inflation, thereby affording it partial inflation protection. Whether investing in a TIPS ETF or fund is beneficial will depend on the future courses of inflation and interest rates. While predicting either one accurately is a nearly impossible task, we know a few things for sure: today’s interest rates are at historic lows and CPI inflation was 3.2% for 2011, and 3.5% for the second half of 2011.

If you compare the yield of a TIPS with that of a conventional US Treasury security you can estimate the “break-even” rate of inflation. On Friday afternoon the conventional 10-year US Treasury closed with a yield of 2.00%, while the 10-year TIPS closed with a yield of -0.25%. (You read that correctly.) Therefore the break-even rate of inflation was 2.00% minus -0.25% or 2.25%. Contrast this with November 28th of 2008 when the break-even rate of inflation in a 10-year TIPS was just 0.35% (2.91% vs. 2.56%). That is, you could buy a TIPS in late 2008 and get the inflation protection almost for free! Exaggerated fears of deflation (falling prices) made TIPS temporarily unattractive to many investors.

Recently, TIPS investors have bid TIPS yields beyond zero to negative levels because they believe that the principal indexation feature of TIPS will be sufficient to raise their total return to positive levels over 10-years. If, however, CPI is zero over 10-years, then today’s TIPS investors will realize a negative return over the 10-year period, and would have been better-off with the conventional US Treasury security.

Buying individual TIPS can be a bit tricky, as auctions are infrequent and most brokers charge commissions of $20 to $50 dollars for securities purchased in the secondary market. Treasury Direct and a few brokers will let you buy securities commission free at the auctions however. ETFs and funds offer diversification and somewhat more friendly tax treatment, but charge annual expense ratios (management and other fees) ranging from 0.10% to 0.50% per year. In taxable accounts TIPS investors are taxed on the “phantom income” that arises from principal indexation. Combining negative yields with positive expense ratios leads to some unusual outcomes as well: many TIPs funds and ETFs are currently offering negative SEC yields. Again, it will require CPI-powered principal indexation to produce positive holding period returns.

An alternative to TIPs that offers a good measure of inflation protection, with reduced interest rate risk, is CPI-linked floating rate Corporate bonds. Some examples offer annual coupons that exceed CPI, paying coupons of 1.5 or 2.0 times CPI, or 0.5% or 1.0% in excess of CPI. CPI-linked coupons are generally paid 3-months in arrears (after the CPI value was calculated and announced). Issuers in this market are generally financial institutions, usually banks and brokers. Unlike the US Treasury and TIPS market, issuer risk is a significant factor to consider in the Corporate floating rate bond market.

TIPs and related ETFs and funds do not appear to be exceedingly inexpensive at this time. However, if interest rates stay near or below 2.00% and inflation remains above 2.00%, then TIPs may be the right place to be. Only time will tell us for sure.

Comment   |  Flag   |  Feb 18, 2012 from Wayne, PA

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Hi Phyllis, I'm guessing you’re asking to buy TIPS directly from the U.S. Treasury or inside a mutual Fund? If so, buying TIPS inside those vehicles will benefit you from professional management, diversification and help alleviate some of the interest rate risk. On the other side of the equation bond mutual funds and ETF's can have negative years and unlike an individual bond you don't know what rate of return you will have. In a rapidly rising inflationary period TIPS and short term government bonds should do pretty well.

Comment   |  Flag   |  Feb 17, 2012 from Cleveland, OH

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