I don’t really love TIPS

This will border on blasphemy for some, but I don’t really love TIPS (Treasury Inflation-Protected Securities) as part of a bond portfolio.  They can serve some purpose, including diversification benefits within fixed income, but for the most part I don’t think most people know what they are buying when they own TIPS.

As a quick review, TIPS are US Treasury bonds that pay annual interest like any other bond.  The difference is that the face value of the bond will be adjusted for CPI each year. So when there is inflation, the value of the bond goes up, and the interest calculation is based on a higher value.  Good deal, right?  The catch is that because of the interest adjustment, TIPS pay a much lower rate of interest than a normal Treasury bond. Right now the 10-Year TIPS breakeven inflation rate is 1.88%, which means that TIPS at auction are going to yield 1.88% less than a nominal Treasury bond.

So in theory, if inflation is higher than what the market anticipates over the life of the bond, then TIPS are a good bet. The trouble with TIPS is that the market gets involved.  People are constantly betting whether inflation will be higher or lower than what is priced in.  And that can lead to some pretty big swings in the value of TIPS in the market, which can translate to bigger performance swings than you might expect from a bond portfolio.

Philosophically, I’m a bonds-as-a-safety-net kinda guy.  Bonds are in your portfolio to generate a modest amount of income, but mostly to be the shock absorber when the markets take a nasty turn. So you want two things from them.  General stability (pretty easy to measure) and low correlation to stocks when things get bad (pretty easy to check out).  How to TIPS stack up? As a proxy, we’ll look at Vanguard’s TIPS Fund (VIPSX), which is about as close to an investable index as you can get.

We can check on the stability issue by taking a look at standard deviation (SD), or how far from the average return the asset is likely to drift in any given calendar year. The SD of the Barclay’s Aggregate Bond Index over the past ten years was 3.26%, with annualized returns of 4.75%.  Not too exciting, which is what we’d want from a bond portfolio.  Over the same time period, VIPSX had annualized returns of 4.20% with standard deviation of 6.4%.  That’s less return and more risk, not exactly what you’re looking for.  And inflation? From 1973-2014 the standard deviation of annual CPI changes is 3.08%.  Less than bonds, and certainly less than TIPS.

So what gives? Why is there more volatility in TIPS than there is in either bonds or inflation? The answer is that people in the market react to the expectation of inflation, and they don’t always get it right.  For example, in 2007 there was a huge market expectation for inflation, and TIPS outperformed the bond index by over 4.5%. But in 2008 those expectations collapsed and the Vanguard TIPS Fund (VIPSX) fell -2.85%, losing value right alongside stocks when the broad bond market was up for the year.  This pattern repeated in 2011-12 and 2013. VIPSX has big gains of 13.25% and 6.78% in ’11-’12, but fell -8.92% in ’13 when interest rates ticked up a hair, and VIPSX underperformed the broad market again in 2014.

The 2008 loss is a strike against TIPS for being stable when the stock market is falling, and it might be reasonable to expect that TIPS and stocks could be down together when there are deflationary fears in the market.

As with most investments, the biggest thing here is to know what you own.  When you buy TIPS for inflation protection, you need to understand that you’re attempting to protect against unexpected inflation, not just inflation.  And in doing so, you’re taking a bit more risk with your bond portfolio. One thing we haven’t discussed here is that TIPS are extremely tax-unfriendly due to the “phantom income” of the CPI adjustment, which is taxable as ordinary income each year.  So if you are going to own TIPS, you need to do so in a tax-sheltered account like an IRA.

Like most assets, TIPS aren’t inherently good or bad.  My fear is mostly that people don’t understand what they own, which is always dangerous.

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