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Time to slay these myths about TIPS

I've heard too many investors and investment advisers alike talk about avoiding Treasury inflation-protected securities, or TIPS. Here's why that's a myth.

TIPS correlate much more closely with inflation than nominal bonds do, both short- and long-term. For example, from their first issuance in April 1997 through December 2011, the quarterly correlation of TIPS to inflation was 0.21. Consider the correlations of Treasuries:

  • One-year Treasuries: -0.18
  • Five-year Treasuries: -0.37
  • 20-year Treasuries: -0.42.

For investors seeking to hedge inflation, this is compelling evidence that TIPS are a better hedge.

TIPS are also negatively correlated with stocks. For the April 1997-December 2011 period, the quarterly correlation of TIPS to the S&P 500 Index was -0.31. A 2004 study, "Asset Allocation with Inflation-Protected Bonds," found that the standard deviation of an equal-weighted portfolio of stocks and bonds is about 13 percent lower for indexed bonds than for conventional bonds. And the risk-reduction more than doubles for more conservative portfolios.

Because TIPS fully hedge inflation, you can extend their maturity and earn the term premium without taking inflation risk. This is an important point many seem to miss. TIPS also have lower expected volatility than conventional Treasury bonds of the same maturity due to lower sensitivity to nominal interest rate movements.

What the experts found

The asset-allocation study concluded that the preference for inflation-protected securities is so strong that if there's no inflation risk premium, the optimal allocation to them is 80 percent. Even with an inflation risk premium of 0.5 percent, the optimal allocation is still 60 percent.

A 2006 study, "Diversification Benefits of Treasury Inflation-Protected Securities," examined both the U.S. and U.K. markets (as an out-of-sample test) and concluded that inflation-protected securities provide diversification benefits that enhance portfolio efficiency (a greater ratio of return to risk): "These findings hold in different economic and inflationary environments, and they confirm the prediction of economic theory that indexed bonds are important for investors who are vulnerable to inflation."

Finally, a 2007 study, "Idiosyncratic Inflation Risk and Inflation-Protected Bonds," found that because of their hedging benefits, investors should hold (for the fixed-income portion of their portfolios) a 100 percent position in TIPS and a zero position in nominal bonds.

Now let's examine in more detail the mythology that has developed around TIPS:

Myth 1: You always pay for protection

The first objection is that investors in TIPS pay for the protection against unexpected inflation. In theory, that's  true. The yield of nominal Treasuries contains three components: the real rate, the expected rate of inflation, and a risk premium for unexpected inflation. TIPS have only two sources of returns: their real yield and the realized inflation rate.

However, as mentioned above, TIPS should still dominate fixed-income portfolios because of their benefits (even if the risk premium is high). This is especially true for investors who are averse to the risks of unexpected inflation, such as retirees. Remember, an asset should never be viewed in isolation. Instead, it should be seen in the context of how its addition impacts the risk and expected return of the overall portfolio.

In addition, the risk premium for unexpected inflation has actually been negative for quite a while. In other words, investors were being paid to avoid the risk of unexpected inflation. When was the last time an insurance company paid you for its taking the risks?

Myth 2: You can fight inflation with short-term bonds

A second objection to TIPS is that short-term bonds represent a better way to mitigate inflation risk. Unfortunately, this is true only relative to longer-term bonds. Short-term bonds don't hedge inflation risk nearly as well as TIPS. (We saw that in the correlation data presented above.)

That's because when inflation rises, the yields on short-term bonds don't immediately respond to the change in expectations, which is what many believe. For example, for the period 1933-1951, one-month Treasury bills produced negative real returns in all but three of the 19 years and produced an annualized real return of -3.2 percent. Beginning in 2002, we saw a repeat performance, with one-month Treasuries producing negative real returns in seven of the 10 years. The annualized return for the period was just 1.8 percent, while the inflation rate was 2.5 percent.

Myth 3: A rise in real rates will always hurt TIPS

Another concern is the expectation that real rates have to rise. Thus, an investment in TIPS will suffer. First, investors (including bond king Bill Gross) have been forecasting rising rates for quite a while and have been dead wrong. That forecast cost them dearly, as they lost the opportunity to earn the term premium, while rates fell even further.

However, the issue is basically irrelevant. If you are confident that real rates are going to rise, you can simply buy short-term TIPS and avoid or minimize the term risk. There is now even a short-term TIPS exchange traded fund -- the PIMCO 1-5 Year US TIPS Index Fund (STPZ) -- available for investors who don't wish to buy individual securities.

Another important point to consider is that the market also expects real rates to rise, as reflected in the steep yield curve. Therefore, staying short only helps if rates rise more than is already anticipated by the market. Not understanding this is a very common and costly mistake often made by both investors and advisers.

Myth 4: Avoid anything with a negative real yield

An additional objection to TIPS I hear regularly goes like this: "Why would I invest in a security with a negative real yield?"

To see why, consider the following example. Ten-year TIPS are currently yielding about -0.3 percent, and 10-year nominal Treasuries are yielding about 2 percent. Given that the current expectation for inflation (from the Philadelphia Federal Reserve's consensus estimate) is 2.3 percent, the expected return on those bonds is -0.3 percent -- exactly the same as it is on TIPS. And with the latter, there's no risk of unexpected inflation.

Hopefully, debunking the faulty thinking around TIPS will help you become a more informed investor.