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How to Combat Risk with TIPS

How investors can find bargains.

Because most bonds pay a fixed amount of interest and mature at par value, increases in inflation tend to lead toward higher interest rates and lower bond prices, explains Mark Salzinger, editor of No-Load Fund Investor.

One way to combat this risk is with TIPS—Treasury Inflation Protected Securities, the principal values of which are increased periodically in response to changes in the CPI.

For TIPS to be a bargain, investors need to purchase them when expectations for inflation are lower than the increase in CPI that actually occurs over the lives of the securities.

To figure the expectation, investors need to compare the yield of a TIP security with the yield of a conventional Treasury security of the same maturity. The bigger the difference, the higher the expectation for inflation, and therefore the more difficult it will be for the TIP security to outperform.

For example, as of April 28, 2017, a conventional 10-year Treasury bond had a yield of 2.29%. Meanwhile, a 10-year TIP security yielded 0.37%, for a difference of 1.92 percentage points in the amounts the securities actually pay out to investors.

Therefore, an investor in the TIP security would need the CPI to increase by more than 1.92% per year over the next 10 years to come out ahead over investing in the conventional 10-year Treasury bond.

One issue we have long had with TIPS is that unless they are held in a tax-deferred account, investors must pay federal taxes on the CPI-related adjustments each year even though they are not received as income.

Another thing to keep in mind is that while inflation is one factor in the determination of interest rates, it isn’t the only one.

Like prices of other bonds with fixed rates of interest (as opposed to changes in principal value due to changes in the CPI), prices of TIPS will decrease if interest rates rise for some reason other than increases in inflation.

We monitor TIPS funds from PIMCO, Price and Vanguard and ETFs from iShares and Schwab.

Over the past three years, performance has been slightly positive on funds and ETFs that invest in longer term TIPS—generally on the order of 1.5% annually or thereabouts.

Funds and ETFs that invest primarily in shorter-term TIPS have earned little—generally a little less than 0.50% per year. Over the same period, low-expense funds and ETFs that invest in conventional Treasuries have done about a percentage point better than TIPS products of comparable average maturity.

Nevertheless, absolute performance isn’t the only factor to consider when determining whether any investment, including a TIPS product, is right for you. Risk reduction is also important for some investors, and TIPS are quite good at that.

They aren’t very volatile, and they offer diversification for accounts that are otherwise invested in securities, like regular high-quality bonds and some equities, with prices that would be clobbered by dramatically higher inflation.

Equally important, they offer this diversification against inflation without the price volatility and risk of loss inherent in other inflation hedges, including gold, other commodities, and real estate, or the downgrade and recession risks inherent in floating-rate/leveraged loan products.

The choice of which TIPS product to choose comes down mainly to risk and expense. The lowest-risk investors may want to consider Vanguard Short-Term Inflation-Protected Investor Shares, with an expense ratio of just 0.16% and an average maturity of 2.6 years.

There is also an exchange-traded fund version, Vanguard Asset Allocation. Vanguard’s longer-term TIPS fund, Vanguard Inflation-Protected Securities, has an expense ratio of 0.20% and an average maturity of 8.3 years.

Mark Salzinger is the publisher and editor of The No-Load Fund Investor, a mutual fund investment advisory that offers analysis, performance data, and 18 model portfolios for investors of various risk levels.

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