U.S. Treasury Inflation-Protected Securities mutual funds (TIPS) have been pitched to investors as a hedge against inflation. But this class of mutual funds has taken quite a beating since May. Should TIPS still be part of an investor’s portfolio?
Individual TIPS are sold at a fixed rate of interest, but if the Consumer Price Index increases from when the bond was purchased, the par value (face value) of the bond is increased. TIPS were originally intended to appeal to investors who wanted the safety of bonds backed by the U.S. government but who wanted protection against the usual downside of bonds — that they would lose value during periods of inflation.
Mutual funds buy a collection of these bonds, so (as with any mutual fund) they offer less of a lock-in of prices, but they can also be more flexible in purchases and sales than the individual bondholder — and therefore more adaptable to current market conditions. TIPS, however, have so far generally been somewhat more volatile than comparable-term Treasuries, because fund prices have been influenced not only by perception of changes coming to the bond market, but also by both current inflation and the anticipation of future inflation.
Like all investments, TIPS should be scrutinized for total return, not just change in price or change in yield. Bond funds have two ways of making you money: The price of mutual fund shares (or individual bonds) can trade higher or lower, and the yield can change. Of course, if you hold an individual bond to maturity, the price you paid won’t change, and your yield is locked in (for better or worse). But a bond fund’s share price changes based on the market for the underlying investments. The yield goes up as the price goes down. Bond funds (and dividend paying stock funds, for that matter) tend to smooth out total return (change in price + yield) based on having these two ways that contribute to the investor’s return. As with all investments, added safety usually results in lower overall return, and TIPS are no different.
As investment types go, inflation-protected securities are a relatively new breed. The U.S. issued its first inflation-indexed securities in 1997, changing the name to a more positive spin. And since the bonds haven’t yet been tested in a highly inflationary environment, much of the guidance on how they will perform remains theoretical. The United Kingdom has issued a similar type of bond (inflation-linked Gilts) since 1981, however, with good average correlations to their Retail Price Index.
TIPS are also at risk of a negative yield. This is when a bond’s coupon (interest rate) minus the current rate of inflation is below zero. Therefore, even short-term TIPS are not a good choice for money you might need right away — they’re not a substitute for a money market fund, for example.
All mutual funds are at the mercy, at least temporarily, of market perception of their asset class. Although this adjusts over time to more accurately reflect the value of the underlying investments, a sudden panic in the bond (or stock) market can negatively impact the share price. For example, in May 2013, TIPS took a plunge because of a downtrend in the CPI and concerns about Fed monetary policy.
No one should invest their entire portfolio in TIPS, both because of volatility and low return. But for those desiring some potential inflation-protection in that part of the portfolio devoted to bonds, TIPS may be worth incorporating.