Pros and Cons of TIPS Mutual Funds
Are TIPS Mutual Funds For You?
TIPS mutual funds invest in Treasury inflation-protected securities, also known as TIPS. The primary advantage of a TIPS fund, compared to some other fixed income securities, is that they can appreciate when during inflationary periods. Therefore TIPS can help investors fight inflation and potentially receive greater returns than a broad market bond index fund.
What Are TIPS?
TIPS are bonds issued by the US Treasury that pay a coupon on the adjusted principal of the bond. The bond is adjusted on a semi-annual basis with the rate of the Consumer Price Index (a measure of inflation). So, TIPS are said to keep pace with inflation by returning the adjusted principal upon maturity and coupon payments along the way.
The Pros of TIPS Mutual Funds
The primary advantage of investing in TIPS funds is that they may increase in value during inflationary periods, whereas conventional bond funds may actually decline in value in the same environment (when interest rates are rising). You can invest in Treasury Inflation-Protected Securities through mutual funds and enjoy many of the advantages.
Here are the pros of TIPS funds:
- Professional Management -- Fund managers will add value by looking for under-priced TIPS in the secondary market.
- Diversification -- TIPS with varying maturities will be owned by a TIPS fund creating a more diversified portfolio.
- Convenience -- Unlike buying a TIPS bond, a TIPS fund can be readily bought and sold in odd dollar amounts. Investors will not need to roll TIPS upon maturity, but can be assured the mutual funds will have constant exposure to TIPS.
- Reinvestment -- As opposed to TIPS bonds, income from TIPS can be automatically reinvested in the fund without a sales charge.
The Cons of TIPS Mutual Funds
Here are the primary disadvantages (the cons) of TIPS mutual funds
- Volatility -- As opposed to TIPS bonds, TIPS mutual funds do not have a maturity, so investors wanting to cash out must accept the current price (which may be higher or lower than the amount originally invested).
- Fees -- There are fees associated with buying TIPS mutual funds that go beyond the transaction fee charged for TIPS bonds.
Tax Tips on TIPS Mutual Funds
Investors in TIPS mutual funds are taxed on both the annual income and the amount of the adjusted principal (i.e., the increase in the principal amount due to CPI) each year. The tax on the adjustment is referred to as “phantom income” because the investor doesn’t actually receive the adjustment in the form of an interest or dividend payment.
Many TIPS mutual funds will pay out the principal adjusted portion as a dividend, but if you reinvest the dividends, it’s a mute point. You are still not receiving the dividend, yet you will owe income tax on the dividend payment. For this reason, many investors wisely choose to hold TIPS in a tax-deferred retirement account (e.g., IRA) to avoid the taxation.
It may seem counter-intuitive, but buying a TIPS mutual fund will not necessarily protect your principal. In the short-term, TIPS funds may be volatile. TIPS are priced on a daily basis based on expectations of future inflation rates (and the value is also affected by changes in interest rates). If you own the TIPS bonds outright, you are assured to receive your adjusted principal upon maturity.
However, unlike individual TIPS, a TIPS mutual fund does not mature. There is not a guarantee that when you want to withdrawal your money, that you will receive the full amount of your investment . Unless you are a speculator, buy TIPS mutual funds for long-term inflation protection for a portion of your fixed income portfolio.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.