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How to Handle Your TIPS Positions

Five takeaways for this asset class as yields inch up and global tensions rise.

Christine Benz, 10/16/2013

This article originally appeared in the October/November 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.  

Treasury Inflation-Protected Securities have been called the only asset class that’s truly risk-free. They are backed by the full faith and credit of the U.S. government, so there’s no credit risk. In addition, TIPS’ principal values adjust to keep pace with inflation, which helps protect owners’ purchasing power. That’s a benefit holders of nominal Treasury bonds do not have. Assuming real yields are positive—and that hasn’t always been the case—someone buying and holding a TIPS bond to maturity is guaranteed a positive real return.

TIPS have also proved to be great diversifiers for stocks during their relatively short lifespan. (The first TIPS were issued in 1997.) Although they didn’t hold up nearly as well as nominal Treasuries during the financial crisis of 2007–09, their correlations with small- and mid-cap U.S. stocks, in particular, are among the lowest of any major assetclass pair.

Sue Stevens, CEO of Stevens Wealth Management in Deerfield, Ill., believes that TIPS roles as diversifiers could continue, too. “We’ve seen TIPS rise in the past as investors seek a flight to safety when things heat up around the world,” she says. “With the possibility of military action in Syria, that could create more demand for ‘safer’ bonds— even if they will drop as interest rates rise.” Indeed, as worries about impending military action in Syria roiled stocks in August, TIPS fared well. Yet that was a rare bright spot this summer, as TIPS—and especially TIPS fundholders—have encountered a perfect storm. With inflation tame, in large part because of slowing growth in emerging markets such as China, demand for the guaranteed inflation protection that TIPS provide is lukewarm.

Moreover, like other bonds TIPs tend to be less attractive when interest rates rise, as they have been recently amid concerns the Federal Reserve would scale back its bond-buying program. The average TIPS mutual fund lost 7.5% for the year to date through Aug. 30.

What’s a sober investor to do in light of TIPS’ recent struggles, as well as what could lie ahead? To help get some answers, I checked in with experts inside and outside of Morningstar to get their takes on optimal allocations to TIPS and also steps one might take if they want to own TIPS without taking undue risk.

1 Begin with the Basics
Before I get into what to do with your TIPS weighting, let’s review how they work. TIPS bonds pay interest twice a year. In addition, TIPS bonds’ principal values regularly adjust to reflect changes in the Consumer Price Index, both up or down. The net effect of that adjustment is that if inflation goes up, so do TIPS’ principal values and in turn their yields. When inflation is falling, TIPS’ principals are adjusted downward, taking yields down in the process. When a TIPS bond matures, the owner receives either the bond’s original value or the value adjusted upward for inflation, whichever is greater.

TIPS watchers regularly keep track of what’s called “the breakeven rate”—the differential between TIPS yields and those of nominal (non-inflation-adjusted) Treasuries of the same maturity. Right now, for example, the yield differential between a nominal 10-year Treasury and a TIPS bond of the same maturity was 2.1% as of Aug. 31, implying that investors, in aggregate, think that inflation will run at about that level in the coming years. But if inflation runs substantially hotter than that, the TIPS investor will be the winner because he will receive an inflation adjustment on his principal, which will translate into a larger dollar payment at maturity as well as higher real yields as he receives coupons during the lifetime of the bond. The owner of the nominal Treasury, by contrast, will see inflation gobble up a higher percentage of the purchasing power of both his interest payments and principal.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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