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Do TIPS Have a Dark Side?

Recently, Rick Ferri had an article on the Forbes Web site discussing "the dark side of TIPS." I've received a number of e-mails about this article, and there are some points that certainly need further discussion. Here are some quotes from the article and some items you should consider about each.

"A jump in the real interest rate presents a big problem for inflation indexed bond holders because neither their par value nor interest income will increase because there is no inflation adjustment."
The author suggests that real rates would rise if foreign investors flee the dollar. First, a rise in real interest rates has a negative effect on all bonds, whether TIPS or nominal return bonds. So switching to nominal return bonds provides no safety over TIPS.

Second, the longer the bond's maturity, the greater the impact of a rise in real rates. TIPS investors concerned about the risks of a rise in real rates can move to shorter-term TIPS. This can be done by purchasing individual TIPS on the secondary market or by using PIMCO's new targeted maturity TIPS ETFs. They have three, including a one-to-five year fund for those that want to avoid the kind of risks discussed in the article. You don't have to abandon the benefits of TIPS even if you wish to avoid this supposed "dark side."

Third, the article fails to mention one of the greatest benefits of TIPS: the ability to extend maturity and earn the term premium (assuming the yield curve is positively sloped, which it currently is) without taking the risk of inflation incurred when extending maturities of nominal bonds.

Fourth, the article misses another important point. You shouldn't make the mistake of analyzing investments in isolation. TIPS have exhibited negative correlation with equities and have provided their best returns just when needed most -- when equities do poorly. And the longer the maturity, the better the return during such periods. When you have a negatively correlated asset, volatility is actually a positive for disciplined investors who rebalance. Thus, the volatility of longer-term TIPS is actually a positive attribute.

Fifth, even if the scenario of rising real rates does play out, TIPS investors still earn the rate of return they contracted for if they hold to maturity. Thus, any "loss" would only be an opportunity cost, not a real loss in terms of spending power. And those investors who are waiting for real rates to possibly rise miss out on the certain term premium available in longer-term TIPS.

"A rise in real interest rates that coincides with low or disinflation (lower inflation) is an inflation-indexed bond holder's bad dream. They would be stuck with low income from their TIPS, no increase in TIPS par value, and lower TIPS prices as bonds react to higher real rates."
First, TIPS hedge deflation even better than inflation, because they can't mature below par. Consider an investor who purchases a 10-year 2 percent TIPS at par and experiences cumulative deflation of 20 percent over the life of the bond. Because the bond matures at par, the real return won't be 2 percent, but approximately 4 percent. Even if a bond is purchased above par, there's no risk from deflation in terms of real returns (the only kind that matter).

Also consider an investor who purchases TIPS at 110 and experiences 10 percent cumulative deflation. While the investor would lose 10 percent in nominal terms on the principal, there's no loss in real terms. They still earned the real return they contracted for. And if the cumulative deflation exceeded 10 percent, the real return would be even greater because TIPS mature at par.

"The only place interest rates can go is up."
First, there are no forecasters with clear crystal balls. Second, the current yield on 20-year TIPS is about 2 percent. That's not far below the long-term average for longer-term Treasuries (about 2.4 percent). Given that TIPS should have lower yields than similar maturity nominal bonds, it would seem like real yields have plenty of room to fall because of the insurance against unexpected inflation. In fact, the yield on the 20-year TIPS was 1.58 percent as recently as March 12, 2008.

"I do recommend only a moderate allocation of perhaps 20% of your bond exposure just in case the unexpected becomes reality."
This blog is about the science of investing. And the recommendations from academic papers are that TIPS should dominate fixed income portfolios. One paper even recommended a 100 percent allocation to TIPS.

If you're interested in learning more about TIPS, my book The Only Guide to Alternative Investments You'll Ever Need has a chapter devoted to inflation-indexed bonds.

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