Investing in TIPS with Less Risk

Kiplinger

Funds that invest in Treasury inflation-protected securities, or TIPS, were supposed to be insulated from big bond market selloffs. At least that's what a lot of investors thought. Even in 2008, a miserable year for most investment categories, the Barclays U.S. TIPS index lost only 2.4%.

See Also: Floating-Rate Notes Are Treasury's New Option for Savers

Then came the bond market's recent mini-meltdown. The TIPS index tumbled 7.1% in the second quarter. That was almost five percentage points worse than the Barclays U.S. Aggregate Bond index, a measure of the overall investment-grade portion of the market. A lot of investors have responded to that unexpected drubbing by yanking money out of what they mistakenly thought was a low-risk investment.

But instead of giving up on TIPS, they should consider a new index fund launched last October. Vanguard Short-Term Inflation-Protected Securities Index (symbol VTAPX) offers inflation protection but comes with relatively little of the interest-rate risk of longer-term TIPS funds. The new Vanguard index fund invests in TIPS with maturities of up to five years. (Vanguard also launched an exchange-traded version of this fund; its symbol is VTIP.)

Why worry about inflation now? After all, inflation is currently running at less than 2% annually --below its long-term average of 3%, much less the double-digit rates it reached in the 1970s. But history tells us that inflation can surge at any time. And the time to buy inflation protection, as with any investment, is when it's dirt cheap. That's the case today, with the prices of ten-year TIPS assuming annual inflation of about 2% over the next decade. If inflation is higher, TIPS will rise in value.

Let's back up a bit. What are TIPS, anyway? They are Treasury-issued securities designed to protect against inflation. Like ordinary Treasury bonds, they make regular interest payments to investors. But the coupons on TIPS are lower than those on ordinary Treasuries because the government promises to pay you more in the end based on what happens with inflation. Every six months, the value of TIPS goes up by the increase in the consumer price index. So if you buy TIPS at $100 and the CPI rises by 1.5% over the next six months, Uncle Sam adjusts the value of your TIPS principal to $101.50. Because TIPS's principal rises, you also receive slightly higher semi-annual interest payments. TIPS are issued in maturities of five, ten and 30 years, with a minimum initial purchase of $100, but many investors purchase them through funds, such as Vanguard Inflation-Protected Securities (VIPSX).

The problem is that TIPS march to two different drummers. Not only do their prices rise along with expectations for inflation, but they also rise and fall along with bond yields. When yields spike, as they did in May and June, TIPS crater. "Investors should take it for granted that TIPS have interest-rate risk," says Michelle Canavan, who covers TIPS funds for Morningstar.

When Treasury yields were declining -- as they had virtually without pause since TIPS were first issued in 1997 -- TIPS funds did just fine. Over the past ten years, Vanguard Inflation-Protected Securities returned an annualized 5.3%, beating the Barclays U.S. Aggregate Bond index by an average of 0.5 percentage point per year. What many investors doubtless didn't realize was that they were making money, in part, because bond yields, including TIPS yields, were plummeting. (All results in this article are through July 24.)

Bond prices and yields move in opposite directions. So when bond yields rose sharply between May 2 and July 5, TIPS nosedived in price. What's more, TIPS were hammered even worse than ordinary Treasuries with similar maturities. Why? Because the market drove Treasury yields higher but continued to foresee benign inflation. That was the worst of both worlds for TIPS investors.

Like most bond funds, the short-term Vanguard TIPS fund is subject to interest-rate risk. But the short maturities of the TIPS it owns limits that risk. If short-term TIPS yields were to rise one percentage point, the price of the short-term TIPS fund would be expected to fall about 2%. In contrast, if long-term TIPS yields were to rise one percentage point, the long-term Vanguard TIPS fund would probably plunge more than 8%. The long-term fund has lost 6.3% over the past 12 months. In the second quarter, the long-term fund plunged 7.3%, but the short-term fund lost just 2.4%.

In a normal bond environment, TIPS, as well as regular Treasuries, would boast much higher yields and, consequently, much lower sensitivity to changes in interest rates. But these are not normal times -- with the Federal Reserve keeping short-term interest rates near zero and buying $85 billion a month in government-backed bonds to keep long-term yields low. (Indeed, some shorter-term TIPS now sport negative yields. That doesn't mean the Treasury is going to take money from you for owning TIPS. It means your return for owning a TIPS will be less than the inflation rate. For example, if you invest in a TIPS with a negative 0.5% yield and inflation runs at a 2% annual rate for the time you hold the bond, your annual return will be 1.5%.)

We've had a 30-year bull market in bonds. I think it's probably over given the selloff in May and June. But thanks to Vanguard, there's still a way to get inflation protection without getting killed in what I think will be a protracted period of rising interest rates.

One last point: Unless inflation soars as it did in the 1970s, TIPS aren't going to make you rich. Short-term TIPS are good, conservative instruments. But assuming normal inflation of, say, 2% to 4%, I think stocks will provide much more generous returns.

Steve Goldberg is an investment adviser in the Washington, D.C., area.

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