The Benefits & Risks of TIPS

Summary of interview with Vanguard's John Hollyer

Learn more about investing in TIPS. Getty Images

Investors should be aware of the benefits and risks of TIPS. Vanguard's John Hollyer was kind enough to answer several questions regarding the benefits and risks of TIPS. This article is an executive summary of the interview and has been provided by Vanguard.

The Benefits and Risks of TIPS

TIPS are designed to preserve purchasing power in the long run by protecting investors against the risk of inflation.

They are bonds issued by the U.S. Treasury that have a fixed rate of interest. However, because the principal is adjusted according to changes in the Consumer Price Index (CPI), the dollar amount of the interest payment also goes up and down. When these securities mature, the U.S. Treasury pays the original or adjusted principal, whichever is greater.

As Treasury bonds, TIPS present virtually no default risk. And since they are indexed to inflation, there is almost no inflation risk (provided your personal rate of inflation is close to the CPI rate). But they’re not risk-free: TIPS market prices move substantially with changes in real interest rates. That means that the share price of a mutual fund investing in TIPS can vary significantly over the short term.

Deflation risk (the risk of a general decline in prices), the opposite of inflation, is another consideration. If there were a long period of deflation, TIPS would potentially lose some value.

However, the U.S. Treasury has pledged to pay any investor in TIPS one hundred cents on the dollar of the principal value.

Factors Influencing TIPS

1. Interest Rate Changes:

  • TIPS prices respond to changes in interest rates, similar to other bonds.
  • Conventional bonds have the expectations for future inflation rates built into their yields.
  • TIPS respond to changes in the “real” interest rates -- current interest rates minus inflation rates.

2. Inflation expectations:

  • Changing expectations of future inflation are often the primary drivers of demand for TIPS.
  • Conventional bonds have the expectations for future inflation rates built into their yields.
  • The spread between conventional  US Treasury bonds and TIPS can mostly be attributed to the expected inflation rate. For instance, if actual inflation is higher than expected, then TIPS will likely outperform conventional bonds and if actual inflation is lower than expected, then TIPS will likely underperform conventional bonds.

The bottom line: Who should invest in a TIPS Fund?

A TIPS fund can play a important role in a diversified portfolio, providing a positive inflation-adjusted return for long-term investors. A TIPS fund is meant to further diversify a well-established, broadly diverse investment portfolio. A TIPS fund should not be viewed as a “be all” alternative to broad bond diversification and investors should use other types of bond funds.

A TIPS fund is not suitable for investors unwilling to tolerate moderate fluctuations in share price, or those seeking long-term capital growth.

For the entire interview with John Hollyer, co-manager of the Vanguard Inflation-Protected Securities Fund: An In-Depth Look at TIPS with Vanguard's John Hollyer