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By Christine Benz and Eric Jacobson | 07-30-2012 01:00 PM

Are TIPS as Safe as You Think?

Morningstar's Eric Jacobson offers a formula to gauge whether TIPS are cheap or expensive compared with other assets but also warns of potential risks should long-term yields rise.

Christine Benz: Hi, I'm Christine Benz for Morningstar. In many respects, Treasury Inflation-Protected Securities would seem to be the ideal choice for retirees, delivering a safe inflation-adjusted stream of income. But in recent years some market watchers have begun to question how safe TIPS really are? Joining me to discuss this question is Eric Jacobson. He is director of fixed-income fund research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Glad to be here, Christine.

Benz: Eric, let's discuss this question. TIPS yields have really gone down a lot over the past few years along with all Treasuries, and so a lot of people are asking how safe TIPS really are given how low yields are and what could happen in a prolonged period of rising interest rates. How can investors get their arms around this question? What's sort of a starting point for that analysis?

Jacobson: Well, the first thing to remember is that even though they have some wrinkles in the way that the cash flows work and the fact that you have the inflation accrual and so forth, TIPS are still bonds. And the fact of the matter is, many of them tend to be very long-maturity bonds. So, even though you have that inflation adjustment built in, which is very helpful, TIPS can and will act like long-term bonds when there are volatility swings in the marketplace. That's one of the reasons that they have done so well as regular Treasuries have done so well, and there is a fairly good risk that if we do see a spike in long-term bond yields, or worse yet, a long protracted rise in long-term bond yields, TIPS are going to feel the pain, especially longer-term maturity TIPS.

Benz: That's really not something we've seen since TIPS were originally created. We haven't had that prolonged period of rising interest rates.

Jacobson: That's exactly right. When they came out they had pretty generous real yields. Those numbers have come in dramatically over the years, and at the same time, we've had this prolonged period of falling nominal Treasury yields. So it's made TIPS look really, really good, and I think part of the risk there is that people haven't experienced that rough period, and so they don't necessarily recognize that [the risk] is out there and that it can happen.

Benz: Eric, one thing we've been hearing from people who focus on this market segment or on bonds in general is that TIPS are expensive. A question is, how does one go about making this assessment about whether TIPS are expensive or cheap at any given point in time?

Jacobson: Well, Christine, the first question that you want to ask is, what are you comparing TIPS to, and the reason for that is the common way to measure whether TIPS are expensive is to look at them relative to Treasuries, and I'll talk about that in a second. But the fact of the matter is, is that most people are really comparing them against other parts of the market as well, and you want to be careful because I can show you in a second how we might look at them and see that they're relatively cheap to Treasuries, but they could still be expensive versus other assets.

So, in terms of that measure, how do you tell? What we typically do is we pick a spot on the maturity spectrum. We look at the nominal or regular conventional Treasury bond. Then we take the yield of that bond, and we subtract the yield of the TIPS bond. That number is pretty close estimate to what they call the break-even inflation rate. Let's say, for example, it's 2%, which is the case for a lot of bonds out past the 10-year maturity point at this time. If that number is 2% then essentially what the market is telling you is that among Treasuries and TIPS there's an expectation of 2% inflation.

If inflation turns out to be lower than 2%, then you would have been better off buying the Treasury bond and holding onto it during that period of time. If inflation turns out to have been higher than 2% over that period, you are going to have done better with the TIPS because the TIP bond will have that embedded inflation accrual and it will protect you if inflation goes over 2%.

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