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By Jason Stipp | 05-24-2011 02:08 PM

What TIPS Won't Do

Vanguard fixed-income manager Ken Volpert says investors may not realize that TIPS won't protect them against rising interest rates.

Jason Stipp: I'm Jason Stipp for Morningstar. Given the fixed income environment, many investors are concerned about and are indeed scrutinizing their fixed-income allocations.

Here to offer some insight on the fixed income space today is Ken Volpert. Ken is the head of the taxable bond group at Vanguard and also a manager on the Vanguard Total Bond Market Index and the Vanguard TIPS fund.

Thanks so much for joining me, Ken.

Ken Volpert: You are welcome, Jason.

Stipp: The first question for you is one that's on the minds of a lot of investors, and it relates to the concerns over inflation and also the TIPS option for investors who are worried about that.

I think that TIPS maybe have some qualities that investors aren't entirely aware off. They don't understand how TIPS might perform in all environments. Can you talk about some of the things that investors who are interested in TIPS for inflation protection should keep in mind?

Volpert: The TIPS actually trade off of what's called the real yield, which is a much lower yield than a typical Treasury nominal bond, and basically the TIPS securities gets that real yield plus whatever the actual inflation is. So, it's important for investors to realize that by TIPS securities, if that real yield increases that actually the TIPS return could turn negative or you can lose some principal value.

Given that we've had this continuing decline in yields in general, I think investors may not realize that; they may think the inflation protection piece gives them protection against rising interest rates, which it doesn't give them.

Stipp: So, often rising interest rates will come along with inflation but they're not always moving exactly at the same time and in the same way?

Volpert: Yes. So, if you have inflation going up by, let's say, it goes up to 4%, you're going to get that 4% in your TIPS return, but with that rise into 4% real interest rates go up 2%, you're going to lose that 2% increase in real rates times whatever the real duration of your portfolio is, and the TIPS fund in general has a real duration of about eight years. So, if [real interest rates] went up 2 percentage points you're going to lose 16% in price and you're going to get 4% in inflation, so you're going to be a very big negative number. We don't expect that kind of an increase in real yields, but that just investors need to realize that that is a risk that you have when you buy a TIPS fund.

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