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By Christine Benz | 05-10-2011 09:58 AM

Don't Go Overboard with TIPS

Morningstar's Eric Jacobson suggests taking a prudent approach for adding TIPS to a portfolio and setting the right expectations for how they'll perform.

Christine Benz: Lastly, Eric, I want to touch on inflation, because that's very much on investors' minds, especially fixed-income investors where inflation is one of the natural enemies of bonds.

How should investors be thinking about that inflation question as they manage their bond portfolio? How to get that inflation protection? How much it should be of their portfolios? What's your take on those questions?

Eric Jacobson: That's a great question, because I think it's something that's been so talked about in the last few years, and I think that we're starting to get to the point where people are meaning different things when they think about it. What I mean by that is, we spent so much time talking about TIPS and how great they are, that I think people have sometimes confused that with whether or not they should be replacing whole other chunks of their portfolio. I guess my point is that TIPS are a good bond substitute. If, however, your overall financial plan dictates that you should own a lot of equities because of your long-term horizon, that may still be the best way to go. Unless you're trying to rein volatility in for some reason, you probably don't want to start swapping out your equities for TIPS because, the truth of the matter is that your best hedge against inflation are in fact equities, because it's just the nature of the beast. That's the way that markets work. You are taking on that risk in order to get a very solid inflation-beating asset, as you know, equities is carrying more risk, that's the whole idea.

Within your bond portfolio, the nice thing about TIPS is that they have that sort of built-in insurance that says to you, even if we have either inflation or deflation, you are going to get certain benefits one way or the other. I think they are a good substitute for low-yielding Treasury assets certainly. I think the more you start to get into those yield-rich areas that may still have some value, you wouldn't necessarily want to substitute them for your high-yield or your emerging-markets exposure, but it might be a good place to swap things out at the lower end.

I think the other important thing to remember, though, is that they are not a big winner in the event of an inflation shock. They are just there to help protect you and perform reasonably well. In fact, if we do see a period where rising inflation or inflation fears spike up at the same time that causes interest rates to spike, during that period, in the meantime, it is very possible that your TIPS bonds will lose money on a market price basis, although again, longer-term structurally they should protect you as inflation goes up.

Benz: So I think that's one question investors grapple with, Eric, even though TIPS might provide that measure of inflation protection, how about interest rate sensitivity?

Jacobson: Yes, it's kind of a complicated answer. I don't want to spend too much time on it because it will be just wrapping us around the axle, but I would recommend that folks go and look at a video interview that we did with Mihir Worah from PIMCO. It's up there on the website, and in it he explains that to some degree, and the fact of the matter is that TIPS are long maturity bonds, many of them are, not all of them. They take on a certain risk because of that. They also have a fixed rate component that is sensitive to changes in what we call real interest rates, and they can be volatile, because when the market sells off to some degree, for example, whether it's frankly either Treasuries or other asset like equities, the market as a whole starts to reprice what it demands from investments in terms of getting that good real return, and if the demand for that real return, says, "Hey, you are not getting enough of it from TIPS today, TIPS will sell off." It doesn't necessarily make them a bad asset, but as you suggest, it does make them a little more sensitive. But anybody who is concerned about that question, I would encourage them to go watch that video and we have had a couple of articles addressing it in the past year or so, too, that they can find on Morningstar.com

Benz: Okay, Eric, well, thank you so much for sharing your insights into how to check up on a fixed-income portfolio today. It's all very helpful.

Jacobson: It's my pleasure. Glad to be with you.

Benz: For Morningstar.com, I'm Christine Benz.

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