What Are the Risks of Investing in TIPS?

Learn the Basics of Investing in TIPS and What Vanguard Says About Their Risks

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Bond mutual funds that invest in treasury inflation-protected securities (TIPS) can be a smart addition to a diversified portfolio. But what are the risks of investing in TIPS funds?

As part of an email interview with John Hollyer, a former co-manager of the Vanguard Inflation-Protected Securities (VIPSX) fund, we asked, “What are the primary risks of investing in TIPS?” John’s answer, in full, is posted on the following pages.

Duration -- A Risk of Investing in TIPS

There are three primary risks of investing in TIPS. The first risk of investing in TIPS is that they are long-duration assets, meaning that they’re generally a longer-term bond (the average life of the TIPS market is about 10 years). While TIPS are indexed to inflation, they do have relatively high price sensitivity to changes in real interest rates (as with any bond, prices and interest rates/yields move in opposite directions.) Yes, bond funds can lose money!

So, while I characterize the yields of TIPS as being the long-term, risk-free rate, in the short-term, their prices can fluctuate pretty substantially. For an investor who’s uncomfortable with price fluctuation, TIPS can be problematic. Their prices will move around.

Deflation -- A Risk of Investing in TIPS

Another risk I associate with TIPS is the risk of deflation -- a general decline in prices (the opposite of inflation). If there were a protracted period of deflation, TIPS would potentially lose some value. However, while the principal will adjust for inflation, if there’s cumulative deflation over the life of a bond, any investor in TIPS will get back one hundred cents of the dollar from the Treasury.

Some people refer to this as a deflation “put.”

Now, 10 years worth of cumulative deflation is relatively unprecedented in modern economic times, but it could happen. This brings into focus an issue having to do with differentiating one TIPS bond from another. TIPS that have been outstanding -- maybe, five or 10 years -- have accrued a fair amount inflation in their current value. And if there were to be protracted deflation theres TIPS could lose that accrued inflation down to the value of par, or the amount the bondholder is entitled to when the bond matures.

So TIPS bonds that have a lot of accrued inflation, at times, will underperform TIPS that are much newer and have almost no accrued inflation. This occurs because of investor concern that accrued inflation could be lost.

We saw this phenomenon at an extreme during the fourth quarter of 2008, when there was so much disruption in the economy and about deflation.

And one of the themes of 2009 was essentially the reversal of the concern. As the market got more comfortable that the Fed’s monetary policy initiatives would be successful at forestalling deflation, those extreme valuation gaps, and the discounts that were being applied to bonds with a high level of accrued deflation, were largely removed.

CPI vs. Your Inflation Rate -- A Risk of Investing in TIPS

A third risk is that the TIPS inflation adjustment is based on the consumer price index (CPI), non-seasonally adjusted. Every household has its own consumption basket, but the CPI is based on a representative consumption basket for households across America.

To the extent that your consumption basket does not match the CPI’s consumption basket, you may find that you’re subject to inflation that isn’t well covered by the CPI.

Two good examples in the last few years would be healthcare costs and college tuition, which have both increased a fair amount above the rate of inflation. So if that’s a big part of your consumption basket, you should be aware of the risk.