The Trouble with TIPS

Interest-rate sensitivity is an issue for TIPS, but there are ways to mitigate it

Christine Benz 28 November, 2016 | 14:10
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After languishing at below-normal levels for the better part of a decade, worries over inflation have flared over the past week following the election results. As Morningstar director of economic analysis Bob Johnson noted, an increase in infrastructure spending, accompanied by tax cuts and decreased regulation, all of which President-elect Donald Trump put forth as economic prescriptions in the run-up to the election, could stoke inflationary pressures. As a result, the so-called breakeven rate--the yield differential between nominal (non-inflation-adjusted) Treasuries and Treasury Inflation-Protected Securities--jumped in the days following the election. The break-even rate stood at 1.71% the day before the election; by Nov. 14, it was up to 1.83%. That's an indication that investors think inflation will be moving up.

Yet despite the heightened attention paid to inflation, TIPS’ prices during this short window went down, not up. That's reflective of the fact that the prices of TIPS, like all bonds, are dependent on the direction of yields. When bond yields go up, as they have recently due to the expectation that the Federal Reserve could raise interest rates as soon as next month, bond prices decline. That's true for TIPS as well as nominal bonds. After all, who wants an old bond with a lower yield attached to it if higher-yielding bonds are going to be coming online?

Moreover, it's worth noting that many of the most widely held TIPS mutual funds maintain longish postures with respect to duration, a measure of interest-rate sensitivity. For example, PIMCO Real Return clock in with a duration of just less than 8 years. That's even longer than the Barclays Aggregate Index, which currently has a duration of less than 6 years. In the 1-week period through Nov. 15, these funds posted losses in line with the Barclays Aggregate Index over that same stretch.

From this standpoint, TIPS look like they could give with one hand in an inflationary environment, while taking with the other. True, holders gain an inflation adjustment in their principal values as the cost of living increases. That translates into a nudge up in TIPS yields, too, as the yields they pay are calculated off of a higher principal value. But TIPS fund holders stand to lose in an inflationary environment, too, as interest rates are often rising when inflation is on the move. TIPS delivered very strong returns after the bonds first came to market in the late 1990s, but they had a major tailwind during much of that period: a declining-yield environment that pumped up bond prices, as well as normal, but not runaway, inflation. Whether that particular scenario will repeat itself any time soon is debatable.

And in any case, TIPS are darn volatile. Over the past decade, for example, the typical TIPS fund has a standard deviation that's nearly twice as high as the Barclays Aggregate Index. Nor are TIPS as liquid as nominal Treasuries; liquidity issues explain why the typical TIPS fund lost 4% in 2008's global market shock even as the Barclays Aggregate Index gained a bit. That's not to say that investors should forego TIPS in their portfolios, but it does suggest that they stay alert to the interest-rate-related volatility that can accompany them. Here are some of the key portfolio considerations to bear in mind when considering a TIPS stake for your portfolio.

Right-Size Your Position

While TIPS can serve a worthwhile role for some investors, not everyone needs them. TIPS are most useful for investors who are close to or already spending from their portfolios and have sizable allocations to fixed-income investments; layering TIPS exposure helps preserve the purchasing power of their income streams. (Notably, TIPS are excluded from the Barclays Aggregate Index, and most core-type intermediate-term bond funds only dabble in them, to the extent that they own them at all.) Morningstar's Lifetime Allocation Indexes for investors in retirement maintain roughly a third to a fourth of their fixed income portfolios in TIPS.

On the flip side, accumulators who are still working and not drawing from their portfolios can probably do without TIPS; not only are such investors apt to be receiving periodic cost-of-living increases in their paychecks, but their total allocations to fixed-income investments are likely pretty modest, too.

Match the Product to Your Holding Period

The original core TIPS mutual funds with long durations and a high degree of interest-rate sensitivity. But some shorter-term TIPS funds have hit the market subsequently. Because they're much less sensitive to interest-rate fluctuations, these shorter-term products are significantly less volatile than their longer-term counterparts.

Of course, over long time frames, the short-term TIPS products will likely return less than those that have more interest-rate sensitivity. But the shorter-term products' lower volatility may be worth it for investors with shorter spending horizons. Such investors can use a short-term TIPS fund as a component of the fixed-income assets they have earmarked for near-term spending needs, while employing a longer-term TIPS fund for portions of their portfolio where their spending horizons are longer.

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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