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By Christine Benz and Eric Jacobson | 01-27-2016 12:00 AM

TIPS Funds: Go Short or Go Long?

Core TIPS funds tend to hold longer-term bonds--bringing more interest-rate sensitivity and volatility--but newer, shorter-term TIPS funds have their own trade-offs.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Some asset managers have been rethinking the maturities of their Treasury inflation-protected securities funds. Joining to discuss that topic is senior analyst Eric Jacobson.

Eric, thank you for being here.

Eric Jacobson: Hi, Christine. Thank you.

Benz: Let's discuss TIPS in general: the thesis behind this asset class and why firms offer these funds in the first place.

Jacobson: The asset class itself is still relatively new. It's less than 20 years old. The original idea was to have a bond, or a bond-like instrument, that would give you good, relatively precise protection from the loss of purchasing power that you get with inflation. We've always had things that people have used as a proxy--commodities, gold. They all have weaknesses that TIPS were designed to try to get around by being a really good proxy for inflation protection.

Benz: Nominal fixed-rate investments tend to be particularly susceptible to inflation. That's why you want to make sure to hedge at least part of your exposure.

Jacobson: Exactly. The idea behind nominal Treasury bonds, regular conventional Treasury bonds, is that the yield is supposed to compensate you for not only taking the risk of giving your money up for 30 years, but also to compensate you somewhat for the risk that inflation is going to eat away at the purchasing power. In theory, they should be priced such that you're protected from that, but you bear that risk when you own the bond and it has a fixed rate.

The idea behind the TIPS structure is that because the principal value adjusts with observed inflation in the marketplace, you don't have to worry about that component. You don't have to worry about your income over that period of time being eaten up by inflation.

Benz: When we saw TIPS funds begin to proliferate, most of them--and it's still where most of the assets lie--have intermediate or longer maturities, correct?

Jacobson: That's right. Some of that is a function of what's out there. The major indexes that track the market tend to be at the long end, and part of the thinking in general is that inflation is a long-term concept, and you want to be able to protect yourself for the long term. So that's where the focus has been.

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