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TIPS Funds: Go Short or Go Long?

Christine Benz
Eric Jacobson

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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Benz: However, there has been some research and some interest recently about whether, say, intermediate-term TIPS also entail a lot of interest rate-related volatility. Vanguard did some really good research in this area a few years ago where they found that the intermediate-term TIPS products were also picking up a lot of volatility along with providing inflation protection.

Jacobson: We could get down in the weeds as to some of the technical details. But one way to think about it is simply this: Even a TIPS bond, which has that inflation adjustment, has a fixed-rate income component. Any time you have a fixed-rate income component paid out over a long period of time, it's susceptible to prices going up and down because it's a fixed number, and values whip around that.

When you add the length of time that we're talking about, either intermediate or very long-term, that kind of long maturity lends itself to more and more volatility. It doesn't negate the value of it as an investment, but I think it has muddied things up for people. It's confused people over the years who thought that because TIPS had this build-in inflation protection, they weren't going to be that volatile. But they are.

Benz: Vanguard has launched a short-term-oriented fund in addition to its core type of TIPS fund, and you have seen some other asset managers beginning to come to market with some more products.

Jacobson: That's right. I think to some degree that was geared--depending on the firm--a little bit toward marketing and people wanting to have another option and so forth. I don't know that, in every case, people understood the fundamental reason why that might be a better idea.

But the bottom line is, you're shifting what you're exposed to when you go from a very long-maturity TIPS portfolio to a very short-maturity TIPS portfolio. With a longer-term fund, [you are exposed to] some of the volatility you get from yields going up and down, and with the shorter-term fund, you're really much more tightly affected by actual changes in CPI.

Benz: You note that other firms are adjusting their core TIPS products to maybe make them a little shorter-term in nature as well.

Jacobson: We don't have a huge basket of competitors in this area, but PIMCO, for example, has always had some specialized portfolios. In addition to their regular real return core TIPS portfolio, some other PIMCO funds layer TIPS on top of other things. They wanted to leave alone the original one, because that is what it is, and they may roll out a short-term fund at some point. But with these other portfolios, where they have a little bit more discretion, they've decided it is muddying things up too much to have that longer-rate volatility in there. They really want this to be more of an inflation tracker, and they want it to be a little cleaner, so they went with the shorter-term TIPS. Their prices are much more directly, narrowly tied to CPI. We don't get all that extra noise of volatility in there.

Benz: How should investors approach this question with their portfolios? Say they have some fixed-income positions that they have earmarked for spending within five years or fewer, and then maybe they've got a longer-term fixed income portion of the portfolio. Should they hold the short-term TIPS product with the shorter-term assets and maybe use the longer-term core product if they have a longer time horizon? How should they approach this issue?

Jacobson: It's certainly reasonable to think in those terms. There are always going to be trade-offs and things to consider, and understand that you may be taking a different risk than you originally expected. So, in general, it's never a bad idea to think in terms of matching those liabilities.

The one thing you want to be aware of with the shorter-term stuff, though, is that because it's tied more directly to CPI, more highly correlated with it, if inflation stagnates or even falls some, you run the risk of feeling that in your [shorter-term] TIPS portfolio.

Now, it's a short-term investment to begin with, so hopefully you are not putting too much concern into whether or not you are making a lot of money there. But it's something to be aware of, that can happen. We're at this odd point in history right now where oil has plummeted in the last 18 months, and if you look at the inflation numbers that the government puts out, we've had inflation falling because of that very volatile energy component. That builds into the overall CPI number that affects TIPS.

Benz: I assume you think investors should also check their core [diversified] bond funds. There may be some TIPS exposure in there as well. So, see what you've got in your other holdings.

Jacobson: That's right. We've seen various levels of that over the years. At some point, PIMCO Total Return had a lot. They still have a good chunk. It varies from manager to manager. Sometimes they look really cheap. A lot of firms won't do more than a few percentage points [of TIPS exposure], but you absolutely want to check your core funds. Broadly, you want to have a sense of, are there things in my bond portfolio that I wouldn't normally expect to be in there. It doesn't mean they are bad. But if you have a bond manager who is holding 10% high yield, for example, that may impact whether or not you have a [dedicated] high-yield fund in your portfolio, too.

Benz: Eric, it's always great to hear your insights. Thank you for being here.

Jacobson: I appreciate you having me. Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.