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TIPS ETFs May Not Protect You From Rising Rates

Roger Nusbaum

NEW YORK TheStreet -- Last week we looked at ways to reduce fixed-income portfolio risks for when interest rates eventually start to move higher.

One segment of the bond market not discussed was Treasury Inflation-Protected Securities, which are more commonly referred to as TIPS.

Simply speaking, the par value of TIPS is increased consistent with the reported rate of inflation. TIPS also pay a lower rate interest at initial auction than comparable Treasuries. By holding TIPS, long-term investors benefit from the inflation adjustments and receive regular interest payments.

The largest ETF in this space is the iShares TIPS Bond ETF .

TIP is the first TIPS ETF, which no doubt contributes to it being the largest in the segment at almost $20 billion. Since TIP's debut in 2003 other providers such as SPDR, Vanguard and PIMCO have entered the space with similar funds that target shorter maturity dates than TIP and invest in inflation-protected securities from other countries.

The enemy of bonds is price inflation, because assets held in bonds won't keep up with inflation. Bonds return your principle when they mature; they don't grow.

If price inflation as reported ever goes up then investors should expect interest rates to also go up, which would result in a price drop in bonds (until maturity) in your portfolio and your interest rate would then be less than newly increased interest rates.

Because TIPS' par value increases at the rate of reported inflation, many investors believe that owning TIPS will sidestep the issue of rising rates caused by increasing inflation.

This is a flawed assumption. TIPS pay a fixed interest rate. If rates go up then the price of a given TIPS bond will still adjust to reflect the increase. Like regular bonds, shorter-dated maturities will be less sensitive to higher rates and longer-dated maturities will be more sensitive.

TIP has been a great hold as the conservative part of a diversified fixed-income portfolio for its low volatility, general slow drift higher in price and payment of some dividends along the way. But since the fund's inception, interest rates have been a one-way trade lower.

TIP has an average weighted maturity of a bit less than nine years, which is far enough out to expect interest rate sensitivity if or when interest rates start to go up.

One alternative to TIP is the PIMCO 1-5 Year TIPS Index ETF . PIMCO lists STPZ' "effective maturity" at at bit more than three years. STPZ will be far less reactive to rising rates than TIP. There is, of course, a tradeoff, which is the yield. TIP has a trailing yield of 1.94%, compared with 0.96% for STPZ.

Both funds can pay dividends monthly, but there is not always a dividend to pay. TIP only paid seven dividends in the trailing 12 months, and STPZ only paid four.

The history of payouts for both funds has been irregular in terms of frequency and amounts. Trying to predict how much either fund may pay in the future would be unproductive, but TIP will yield more while STPZ will offer better protection against rising rates.

At our firm, most clients own TIP. We would expect over the next year or so to migrate to STPZ, especially if we get more clarity from the Fed as to when quantitative easing might end.

At the time of publication, Nusbaum's firm held shares of TIP and STPZ on behalf of clients.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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