The Real Risk in TIPS

by: IndexUniverse Europe

By Paul Amery

Are investors setting themselves up for a beating in inflation-linked bond ETFs?

I’ve been following the debate around Dave Nadig’s recent blog on with interest.

Dave points out the potential risk from a rise in nominal interest rates to investors in TIPS, while Larry Swedroe, in his comments on the blog, argues that investors can lock in with certainty the real yield at which they acquire a TIPS portfolio, as long as they hold to maturity.

Both Dave and Larry are undoubtedly correct. But the problem for me with Larry’s approach is that it might well be possible to lock in a higher real yield by waiting a month or a year. Investors are not insensitive to market levels, in other words, and buying TIPS at too low a real yield level represents a potentially large opportunity cost.

As I pointed out in a feature on last November, real yields in the UK, US and France have been trading at historic lows, partly due to investors’ concerns over the potential inflationary impact of large budget deficits. There has been large-scale buying of inflation-linked bond ETFs over the last year, reflecting these fears and pushing real yields down.

Since November, however, there has been a distinct move upwards in real yields in the US and UK inflation-linked markets, particularly at longer maturities, as the table below shows. The break-even inflation rates for the selected bonds on the same dates (i.e. the average annual inflation rate at which inflation-linked and conventional, fixed rate bonds would give the same return) are also given. Data come from the Financial Times website.

Inflation-Linked Bond

Real Yield 30/11/09 (%)

Real Yield 10/02/10 (%)

Break-even Inflation Rate 30/11/09 (%)

Break-even Inflation Rate 10/02/10 (%)

UK 2.5% 2016





UK 2.5% 2024





UK 2% 2035





US 3.625% 2028





The behavior of the 2028 US TIPS is a salutary reminder that investors should focus primarily on real yields, not inflation expectations, when valuing inflation-linked bonds, however paradoxical that may sound. Although the US break-even inflation rate has risen since November (meaning that investors are factoring in more inflation over the next 18 years than they did three months ago), those holding the 2028 TIPS have lost money, as real yields have climbed by 33 basis points over the same period. That yield change equates to a capital loss of around 4.5% since end-November on the 2028 TIPS, assuming a modified duration of 13.8 years.

For the UK’s 2035 index-linked bond, whose real yield has nearly doubled over the same period, the capital loss has been a more dramatic 9.2% since November (45 basis points multiplied by a modified duration of 20.41 years).

If you invest in inflation-linked bond ETFs you are protected, to some extent, from the interest rate sensitivity of longer-dated bonds by the portfolio approach that these funds take (i.e. they spread their investments over a range of maturities). However, even these ETFs have felt some impact from rising real yields and falling bond prices over the last couple of months.

The recent price decline is more obvious in the iShares £ index-linked gilt ETF than in the iShares US TIPS ETF (see below), partly because the UK inflation-linked bond market and its associated index is skewed to longer maturities (with an average duration of 14.35 years) than the index that the iShares TIPS ETF tracks (with a duration of 7.75 years).


Nevertheless, as historian Niall Ferguson reminds us in an article in today’s Financial Times, “Explosions of public debt hurt economies in the following way, as numerous empirical studies have shown. By raising fears of default and/or currency depreciation ahead of actual inflation, they push up real interest rates.”

And even without default fears, if real yields were to rise to their historical trading range of over 2%, let alone the 4%-plus rates that prevailed in the mid-1990s, then inflation-linked bond investors would be in for a real beating.

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