TIPS Come of Age and Get a New Category

The biggest surprise surrounding Morningstar's new inflation-protected bond category is just how long it took to populate.

There have been a handful of funds focusing on Treasury Inflation-Protected Securities almost since the day those U.S. Government securities became available in the late 1990s. The very design of TIPS is so novel and so investor-friendly that some of us at Morningstar expected that investors would flock to them. The complexity that underlies the appeal of TIPS, however, was a deterrent to investors. Many stayed away, preferring to wait and see how they performed. Institutional investors eventually began to come around, and individuals continue to grow more comfortable with TIPS. The growing number of TIPS funds--roughly 25 at last count--prompted us to create a separate category for them. (Morningstar also recently created new categories for long-short and target-maturity funds.)

The Basics
It's true that many of the details surrounding TIPS involve arcane bondspeak. But while similar bonds have been around overseas (Canada, the U.K., and Israel, in particular) for years, their very design is unique in the U.S. market.

What's so unusual about TIPS? Well, investors familiar with conventional bonds, Treasury or otherwise, know that most have a face (also known as par, or principal) value of $1,000 per bond, an immutable number that never changes. Like conventional bonds, TIPS pay a fixed rate of interest, expressed as a percentage of their face values. What makes them special, though, is that TIPS' face values are adjusted, in line with the government's consumer price index, between the time they're issued and when they mature. So while a TIPS issue may always carry a fixed rate of say, 3%, the amount of income it pays each year will be 3% of whatever its face value is at the time. (They pay interest semiannually, so the actual number will be slightly different.) The end result is that investors get an assurance that their principal will be indexed directly to the consumer price index. And by extension, their interest payments, while expressed as a fixed percentage, will be a fixed percentage of a principal amount that should move along with inflation.

Here's the upshot. The principal amount of a conventional bond remains fixed, and thus becomes less valuable over time (as measured by purchasing power) as long as inflation exists. So, if you buy a Treasury bond for $1,000 today, and you get that $1,000 back in 30 years, you can generally count on the purchasing power of that money being less. (The fixed amount of interest you earn over the years is meant to try to compensate for that loss, but high inflation foils such plans.) As long as your principal is indexed to inflation, though, as in the case of a TIPS issue, you can enjoy some assurance that your purchasing power will keep up.

Does Everyone Need TIPS?
So, does that mean everyone should run out and buy a TIPS fund? Well, yes and no. The unique profile and appeal of TIPS do argue that almost any long-term investor should find a portfolio slot for a TIPS allocation. Although there are other investments available that offer the promise of an inflation hedge--natural resources and precious metals, for example--there aren't really any that provide as direct and certain a link to what the U.S. government considers to be the cost of living.

There's a common misconception, however, that the indexing of principal inherent with TIPS makes them safe in all circumstances. The fact is, however, that over short periods of time, TIPS funds can lose money when interest rates rise, just as is the case with conventional bonds. How TIPS behave depends a lot on where we are in the interest-rate cycle and the overall level of income that investors are demanding from the bond market. The net result is that during periods of low overall market yields, TIPS tend to be more highly correlated with conventional Treasury bonds; they are less so when yields are higher. In fact, over short time periods, TIPS can be pretty volatile, rising or falling as many as a few percentage points in a single month, for example.

Moreover, it is possible for TIPS to look cheap or expensive relative to other bonds. When they were first issued, for example, TIPS paid yields somewhere in the neighborhood of 3.5% to 4.0%, above and beyond their inflation-adjusted principal levels. Despite the tepid investor response at the time, it seemed pretty clear that was a good bargain. By contrast, today's TIPS yields are smaller, generally hovering in the 2% range depending on maturity. Depending on the yields for conventional Treasuries, that number might look pretty small by comparison. You can make your own determination by subtracting the TIPS yield from a similar conventional Treasury to deduce the market's expectations for inflation. If a comparable, conventional Treasury issue carried a yield of 4.5%, for example, that would imply inflation expectations of 2.5%. If the result is lower than your own inflation expectations, the TIPS issue would be more attractive than the comparable, conventional Treasury, and vice versa.

Should I Just Do It Myself?
Should you buy a TIPS fund instead of the bonds themselves? The answer to that question isn't cut and dried, although we would err on the side of a fund. As a large and growing sector of the U.S. Treasury market, one wouldn't expect the level of market inefficiency that might normally drive one to believe that an active manager can add significant value. But TIPS are still relatively new, and there are occasional opportunities for managers to make profitable trades. More important, though, is that understanding TIPS bond pricing in the marketplace can be difficult, and individual investors looking to buy and sell them through retail brokerages are likely to face an uphill battle finding someone other than a firm's high-level traders who can work with them effectively. Of course, the Treasury also offers inflation-protected savings bonds, which can be purchased in moderation, and they're usually a good option. (Check out this Morningstar article on the topic.)

Who's Got the Goods?
At the moment, most TIPS funds pursue a pretty plain-vanilla strategy, holding mostly U.S. Treasury-issued bonds and little else. If that's what you're looking for, we'd recommend keeping a sharp eye on costs. There are a handful of particularly cheap options including one of our favorites,  Vanguard Inflation-Protected Securities (VIPSX), which charges just 0.17% per annum.

Until recently, small investors who were willing to take on some risk with more complex and profitable strategies had little choice but to go with one of the pricey share classes of the otherwise excellent  PIMCO Real Return . Harbor funds, though, recently rolled out a fund subadvised by PIMCO, run by the same manager, with the same strategy. And that fund,  Harbor Real Return , will be charging a modest 0.57% for the foreseeable future. It's certainly a more aggressive pick than the Vanguard option, but one that we think makes sense for investors willing to put their trust in PIMCO and manager John Brynjolfsson.

The bottom line is that this category represents a true innovation for bond investors. And while we would counsel some caution--and perhaps dollar-cost averaging if you have a big chunk of money to invest--we think it makes sense for just about any long-term investor to carve out some portfolio space for a TIPS-focused fund.