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What Should You Do With Your TIPS?

With yields up and inflation tame, is this asset class still a must-own?

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Treasury Inflation-Protected Securities, or TIPS, have been called the only asset class that's truly risk-free. The securities 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 bonds 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 asset-class 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 earlier this week, 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, TIPS, like nearly every other bond type, tend to be less attractive when interest rates are rising, as they have been recently amid concerns that the Federal Reserve would scale back its bond-buying program. Why settle for an old bond with a low coupon attached to it when a newer higher-yielding one is likely on the way?
Owners of individual TIPS bonds may not have noticed all of the hubbub, but TIPS fundholders probably have. The average TIPS mutual fund has lost 7.5% for the year to date through Aug. 26--only long-government and emerging-markets bond funds have incurred larger average losses. Popular funds in the category, including the gold-rated  PIMCO Real Return (PRTNX) and  Vanguard Inflation-Protected Securities (VIPSX), have posted losses in the 8%-9% range.

Furthermore, storm clouds still loom for TIPS. Even as bond yields have jumped during the past few months, yields still have a lot more room to move up than they do to go down. Stevens notes, "Although TIPS investors have a component of their total returns tied to how inflation changes, it may not be enough to offset the drop in value from rising interest rates."

Rick Ferri, author of several investment books and founder of asset-management firm Portfolio Solutions, believes the past few months have provided a glimpse into what could happen if bond market participants decide rates should no longer stay artificially low. "The bond market is extremely powerful, but it let's the Fed led it on by a shoestring," he says. "When the market decides it's not going to be led, then rates can go up very quickly."

The Math on TIPS
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.
Before getting 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 2.13% as of Aug. 23, 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. With breakeven rates dropping, Stevens believes that "TIPS today are a better buy than they were last year."

Revisiting Recommended Allocations
But does that make them worth owning? In a previous article, I discussed the role that TIPS should play in long-term portfolios, sampling allocations from Morningstar's Lifetime Allocation Indexes as well as top target-date fund series, such as those from  T. Rowe Price Group (TROW) and Vanguard. The prevailing theme across all of these asset-allocation frameworks is that for most individuals, TIPS should be a relatively unimportant part of their portfolios when they are in accumulation mode. The thinking is that such investors, assuming they're working, are likely seeing some kind of cost-of-living-adjustment in their paychecks, and they are also likely to hold heavy weightings in stocks, which have historically outpaced inflation.

By contrast, for individuals who are retired, TIPS consume a greater share of both Morningstar's allocation indexes and the target-date series. That's because such individuals rely on at least part of their portfolios for living expenses, and therefore they're not receiving an inflation adjustment in that part of their "paychecks." Additionally, bonds generally consume a larger percentage of most retiree portfolios.

For example, Morningstar's Lifetime Allocation Indexes, revised in 2013, start with zero in TIPS for young accumulators, begin adding tiny TIPS stakes 25 years before retirement, and step up the TIPS weightings in earnest five years before retirement. The portfolios geared toward retirees generally stake about 30% of their bond assets in TIPS. The T. Rowe Retirement portfolios follow a similar pattern, culminating in a 30% TIPS stake for  T. Rowe Price Retirement Income (TRRIX), the vehicle geared toward retirees.

Vanguard's Target Retirement funds also downplay TIPS for accumulators, but are generally less heavy on TIPS for retirees. A small stake in TIPS pops up in portfolios a few years before retirement--for example, Vanguard's Target 2015 fund (VTXVX) has a roughly 5% position--ending in a 17% stake in Vanguard Target Retirement Income fund (VTINX). (Vanguard's target-date series has also recently switched its TIPS exposure from Vanguard Inflation-Protected Securities to Vanguard Short-Term Inflation-Protected Securities Index (VTAPX).)

Implementation Questions Remain
But what size TIPS weighting makes sense now, given the headwinds that could lie ahead for the asset class?

Ferri thinks holding one third of a bond portfolio in TIPS sounds too high, and not just because of temporal factors. "I've never been in the school of high TIPS allocations as others have advocated," he says. "My view has always been to hold between 10% and 20% of a fixed-income portfolio in TIPS or I-Bonds as a hedge against unanticipated inflation. Any more than that seems to be an overly large bet on an upward surprise in inflation."

Morningstar's director of economic analysis Bob Johnson, like other experts I spoke with, agree that TIPS are most valuable to retirees, who can ladder the bonds so that their maturities coincide with the retirees' expected needs for funds. "I am always very intrigued by TIPS, but they are exceptionally volatile and often confuse individual investors," Johnson says. "I always think the best way to use them is to match actual purchases of individual bonds against known needs." 

Because the bonds are held until maturity, there's no risk of capital loss, no matter what happens with interest rates.

Asset-allocation guru William Bernstein described exactly that approach--often called a liability-matching strategy--in his most recent e-book, The Ages of the Investor: A Critical Look at Life-Cycle Investing. "I find this to be a very elegant and nearly riskless way of paying inflation-indexed retirement expenses," Bernstein says of a laddered portfolio of TIPS. He notes, however, that because mutual funds don't have maturities, they don't work in a laddering framework. "The problem is that when you own [TIPS] in a fund, you lose the riskless-at-maturity feature, which is one of the reasons why I don't like TIPS mutual funds and exchange-traded funds."

Fees are another reason Bernstein eschews TIPS funds and ETFs. He says, "Why pay anyone a fund fee, no matter how small, when you can own them for nothing and hold them to a real riskless maturity?"

Stevens says she likes the approach of laddering TIPS bonds to meet obligations in retirement, but believes that in practice, it can be more complex than it sounds. "I think it's tricky buying bonds at a reasonable price. If you are buying them in the secondary market, you have to watch the premiums," she notes. Instead, she recommends that "if you are retired, or more risk-sensitive, you may want to reduce the potential short-term losses by shortening up your duration [a measure of interest-rate sensitivity] in a short TIPS fund." 

A fund doesn't lend itself to laddering, of course, but owning one focused on short-term maturities helps lessen the odds that you'd have a loss during your holding period.

Ferri thinks short-term TIPS can also make sense as a parking place for monies needed for near-term expenses. "If an investor has the money they need for college, a wedding, a home, and so on, and they believe there is a high risk of inflation jumping before the money is needed, then the short-term TIPS fund may be a good solution."

Stevens also thinks that investors with longer time horizons who are using TIPS to help diversify their portfolios could reasonably sit tight with their holdings. "If you already own a core fund like Vanguard Inflation-Protected Securities, you have to ask yourself what you are trying to achieve with your TIPS. If you want to hold them for the long term as part of a diversified bond strategy, then I wouldn't change anything." 

Although core funds are apt to have much more short-term volatility than short-term funds, she thinks their long-run return potential is better.

The broad takeaways from these experts--and from life-cycle portfolios and indexes--are that TIPS aren't a must-have for accumulators' portfolios, but a bulwark against inflation still makes sense for retirees. To help guard against the interest-rate-related risk that is part and parcel of investing in a core-type TIPS fund, retirees can employ laddered portfolios of TIPS bonds, as Bernstein suggests. Alternatively, a short-term TIPS fund can help provide pure inflation protection without a lot of interest-rate-related volatility. Such funds can also serve as a viable parking place for near-term needs that would otherwise be parked in cash.

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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.