TIPS Funds: Where Do They Fit In?

| About: iShares TIPS (TIP)

Summary

Warning: TIPS funds are a more than just an inflation play.

Depending on your objectives, they may make sense as an alternative to individual TIPS bonds.

Key metrics to focus on are yield to maturity and expenses.

Worried about a pickup in inflation? Many of the major fund families proffer funds and ETFs that invest in Treasury Inflation Protected Securities ("TIPS"). While these may appear to be the ultimate sleep-at-night investment, there are some important differences compared with owning TIPS bonds outright.

Using individual TIPS and holding them to maturity for inflation protection is a "yield-to-maturity" approach. You buy TIPS at auction or in the secondary market and lock in an inflation-adjusted ("real") yield. There are some caveats which I discuss here but by and large, your return is guaranteed. When buying funds (in either a mutual or exchange-traded flavor), you're in the land of "price return". Since funds have no set maturity date, your return will be a function of the price when you sell and may or may not match inflation.

To compare a direct investment in TIPS with a fund investment, I looked at the IShares TIPS ETF (NYSEARCA:TIP), the largest fund by assets at about $18 billion. TIP holds a broad cross-section of outstanding TIPS and nothing else of consequence. Its average maturity is 8.7 years. I wanted to compare the returns of buying the ETF to buying individual bonds. For the direct investment, I used market yield data for the constant maturity 5-year TIPS. This represents the "real" yield that you would have locked in if you had bought the bond and held it to maturity. I compared this forward-looking yield with the backward-looking, "real" return of owning the TIP ETF for five years. (Example: the last plotted TIP return on the chart is the inflation-adjusted return realized from March 2011 through March 2016.)

Click to enlarge

Data sources: Federal Reserve; Yahoo!Finance

You can see from the chart that the results for the two alternatives are correlated (specifically, the correlation coefficient is 0.81) but that the ETF significantly outperformed the directly held bond.

To understand why, a quick detour into what drives TIPS returns. TIPS are bonds. Just as regular Treasury bond prices are a function of nominal interest rates, TIPS market prices are a function of "real" interest rates. "Real" interest rates are unknown but conceptually are driven by 1) nominal interest rates, and 2) inflation expectations:

Real interest rates = Nominal interest rates - expected inflation*

Note that expected inflation is not the same as actual inflation. Expected inflation is unknown (though estimated in various ways), whereas actual inflation is known.

It's clear from this relationship that, all else equal, decreasing interest rates and increasing inflation expectations benefit TIPS. Conversely, increasing interest rates and decreasing inflation expectations hurt TIPS prices.

Increase in interest rates

Decrease in interest rates

Increase in expected inflation

Uncertain impact

Higher price (lower "real rates")

Decrease in expected inflation

Lower price (higher "real" rates)

Uncertain impact

Click to enlarge

With this as background, let's return to the ETF vs. direct returns. The period shown was a good time to invest in TIPS funds. This mostly is due to the decline in nominal interest rates. In particular, the rapid rise in the ETF returns for investments made between December of 2004 and June 2006 was helped by the drop in interest rates in the ensuing five years (2009 to 2013.) The 10-year Treasury rate dropped from 3.5% to 1.6% over this period. It was a good time to invest in TIPS because it was a good time to invest in bonds generally.**

Of course, this can play out in reverse. Unlike regular bond funds, as the TIPS owned by ETF funds approach maturity, they will yield the real rate that is locked in when you purchase the fund shares. But in the interim, month to month TIPS returns are interest sensitive and correlated with nominal Treasury bonds (see chart below.) Explaining, let alone predicting the direction of TIPS prices has proven difficult. While theory suggests that "real" interest rates, and thus TIPS prices, should be relatively stable, this has not always been the case. During the financial crisis, TIPS prices plummeted by more than 17% between August and November 2008 but had more than recovered by the end of 2009.

Click to enlarge
Data source: Yahoo!Finance

For investors seeking a guaranteed inflation-adjusted payoff on a particular date, TIPS funds won't provide reliable protection. And arguably, if you want to take a view on real interest rates, you don't need a fund to do so. Since most of the funds just hold TIPS bonds, there is no meaningful diversification from buying a fund - an individual issue with your desired duration should give you the return without the management fee.

So when does it make sense to buy funds over individual issues? Here are some instances:

  • If you have an indeterminate (or extremely long) time horizon, funds provide "evergreen" inflation protection - over time the real returns should provide a floor return if you can ride out interest rate cycles (although with the limited available price history, this is not a hypothesis that I have seen tested.)
  • Conversely, some short duration TIPS funds are less interest rate sensitive and may be appropriate for maintaining purchasing power over a short period, e.g., 2 or 3 years. Just remember, if rates move up dramatically, even a short-duration fund will suffer.
  • You might consider TIPS funds for the fixed income portion, or at least some of the fixed income portion, of a diversified portfolio. TIPS have low correlation with stocks, even lower than nominal bonds, while providing a real return.
  • Funds may make sense for taxable accounts because they pay out the annual increase in the TIPS principal due to inflation. This avoids investors being taxed on income they don't actually receive until the bonds mature.
  • Finally, reinvesting your income is greatly facilitated with funds. It is much more cumbersome with individual bonds.

Here are some considerations if you do decide to pull the trigger on a TIPS fund.

TIPS funds come in a handful of flavors. The most plain-vanilla simply own a cross-section of the 99 outstanding TIPS issues. They measure themselves against the Barclays U.S. Treasury Inflation Protected Securities Index, which by definition includes all TIPS with maturities longer than 1 year, or a similar Merrill Lynch index. They tend to have average maturities in the 8-9 year range. The hands-down lowest cost general TIPS ETF is the Schwab U.S. TIPS ETF (NYSEARCA:SCHP) with an expense ratio of 0.07%.

Then there are funds that target shorter maturity TIPS (3, 5, or 10 years.) Like shorter duration nominal bond funds, these would be expected to be less sensitive to interest rate changes. On the other end of the spectrum, there is the PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (NYSEARCA:LTPZ) with an average maturity of 25.75 years.

There are also international/global inflation protected funds (e.g., ITIP, GTIP, WIP) that tend to have significant exposures to U.K., French, Italian and Brazilian inflation-indexed bonds, with or without exposure to the U.S. market.

When buying any TIPS fund, the headline numbers reported on fund summaries, such as historical returns, trailing yields and the like are not very helpful. The past is definitely no indication of the future. In addition to investment objectives, the key focus should be on expenses and the real yield of the fund at the time of purchase. This yield represents the "locked-in" return as bonds in the fund mature. For a specific fund, this may require some digging through the disclosures. If you can't find the real yield, find the yield on an individual TIPS bond with roughly the same maturity as the fund average. For example, for May 12, 2016, TIP reported an average maturity of 8.67 years and a real yield of 0.0%, meaning the fund should match inflation over time. Looking at the Wall Street Journal's market data, the closest TIP matures in July of 2015, yielding 0.038%. Needless to say, at these yield levels, expenses when choosing a fund become critical.

Here is the history for the 10-year TIPS - as you can see, "real" yields recently have fluctuated between zero and 1%, but negative yields are quite possible.

Click to enlarge

Data source: Federal Reserve


* Sometimes an "inflation risk premium" is identified separately to reflect that there is uncertainty about the expectation. For this illustrative purpose, expectations include the uncertainty.

** Another reason for the lower direct TIPS yield is the longer duration of the fund. I chose to compare the 5-year TIPS yield with a five-year holding period.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.