How TIPS Can Help in a Portfolio

Karen Wallace: After laying low in 2015 and 2016, inflation rose 2.8% over the last 12 months. Here to discuss how inflation-protected bonds work and the role that can play in a portfolio is Eric Jacobson. He is a senior analyst on our fixed-income manager research team.

Eric, thanks so much for being here.

Eric Jacobson: Thank you. Glad to be here.

Wallace: Let's start by just discussing what TIPS are and how they work.

Jacobson: TIPS are bonds with an inflation protection built in. The way that that works is, their underlying prices are indexed to the CPI, the Consumer Price Index. The idea is as the CPI goes up, eventually their prices should follow.

Wallace: What are some of the risks of TIPS? People say this is a risk-free asset, but what does that mean?

Jacobson: They aren't exactly risk-free, because they are bonds and they do have sensitivity to interest rates. In other words, as yields move up, for example, the price of TIPS can go down. Now, people think that they are risk-free because their end payment or the maturity value is going to be indexed to inflation, and you can't get less than you paid for them. Along the way the price can go up and down quite a bit. They tend to be very long-duration, long-maturity instruments, and the price can swing up and down all around which they do, and they are pretty rate-sensitive.

Wallace: Even the inflation-protected feature isn't guaranteed if you sell it before maturity?

Jacobson: That's right. The underlying principal value will probably creep up a little bit every year as long as we have some inflation, which is what we get. Instead of being $1,000, the underlying principal value will go up, maybe $1,200, $1,300 over a long period of time. But on a day-to-day basis, they are going to trade like other bonds. If it has a 3% coupon and yields move up 25 basis points or 50 basis points, the price is going to go down and that's going to happen quickly. They tend to be pretty volatile depending on how long maturity they are.

Wallace: TIPS might not be something that every investor needs. Some people may say, I have a lot of equity exposure; I'm protected from inflation through that. Who do you think TIPS make sense for and what role should they play in a portfolio?

Jacobson: That's a good point in that there are investors who feel very comfortable with their equity investments, that over a long period of time they are going to protect them from inflation. But there are a lot of people that want more balance in their portfolio. The nice thing about TIPS is, you are definitely going to at least pace with inflation with a TIPS bond. The other thing is that when there's a crisis and when other assets are getting killed because they have a lot of credit risk or equity risk and so forth, TIPS will generally hang in there pretty well. It's not all the time. They are not as liquid as regular treasuries, but they are government-backed bonds. They are a source some stability and safety. Even if they can be pretty volatile in the short-term, long-term they are a very good inflation hedge.

Wallace: What are some of the inflation-protected bond funds that we recommend? What are some of the strategies that are best-of-breed?

Jacobson: There's a couple that we like a lot. The first one is Vanguard Inflation-Protected Securities. Like a lot of other Vanguard funds as you'd expect, it does have some active management, but the TIPS market is very efficient relatively speaking, and there's not a lot you necessarily want to do. It's a pretty plain-vanilla fund and it's really, really cheap. That's one we like a lot.

The other one is PIMCO Real Return. Much like other PIMCO bond funds, they have sort of a base level of exposure to TIPS, and then they have some different techniques that they use to try and add to the returns of TIPS. Depending on which kind of PIMCO Real Return Fund, there's a couple of varieties--some of them use commodities; some of them use short-term bonds that they layer on the top of it. That fund tends to be a little bit more volatile than most of the other TIPS funds. If you figure that you are going to hold something for a very long time and you want to try and get a little bit more return, that's the one to go with.

Wallace: Eric, thanks so much for being here today to discuss this.

Jacobson: I'm glad to be with you. Thanks, Karen.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.