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By Dave Nadig

It’s not that bonds are bad, it’s just that they’re misunderstood.

Matt Hougan is right to suggest that investors in BlackRock’s iShares TIPS ETF (NYSEARCA:TIP) may not really understand what they’re buying, but he stops short of actually explaining what TIP investors should really be expecting. Let’s take a look at how TIPS (in this case, represented by the BarCap US Inflation Linked Bond Index) has done vs. the Consumer Price Index since the mid-90s. I tossed in a line for the fed funds target just for fun:

IU_Duration_The_Looming_Scandal

There are a few things worth noting.

First, as Matt suggests, in general, the moves in TIPS have little to do with the actual fluctuations in the CPI. That’s not because they’re broken; it’s simply that movements in the bond market have historically dwarfed movements in CPI. The one period where we saw real movement in the CPI—late 2007 through mid-2008—looks like it was good for the bond market, but the real story was the collapse in interest rates coinciding with the flight to quality, which drove up the value of bonds. When the CPI tipped into deflation, the bloom that came off the TIPS rose dramatically, far out of proportion to the actual blip in the CPI.

The real levers on TIPS returns are (unfortunately for inflation fighters) the structure of the yield curve and duration.

For an investor in TIP right now, duration should be the real concern. Duration is a measurement of a bond portfolio that implies how much the principal in the fund will be affected by movements in interest rates. When you look at a bond ETF and it shows a duration of 10, it means that a 1 percent increase in interest rates will translate into a 10 percent drop in principal value. Of course, that’s no guarantee, and duration, like price/earnings, can change in a hurry, as the yield curve flops around.

So what does that mean for TIP investors? With a duration of about 4, a 1 percent increase means a 4 percent loss in value. Should the Fed engage in systematic tightening—like they did in 2004-2005, when they jacked rates 4.25 percent—that would theoretically translate into an approximate 15 percent negative surprise.

Of course, there are no sure things, and just looking at the chart can tell you that the total return of TIP hasn’t reacted in lock step to the academic definition of duration.

But at the end of the day, as much as it pains me to say it, TIP investors probably should be concerned, or at least be keeping a very watchful eye on the Fed.

Original post

Source: Duration and TIPS: The Looming Scandal