What You Need to Know About Investing in TIPS Funds

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. Investors are wise to learn more about these unique fixed income securities prior to investing. Here we will discuss the risks of investing in TIPS and they are a good idea for you and your investment goals.

Risk of Investing in TIPS: Duration

There are three primary risks of investing in TIPS and TIPS funds. 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.

Risks of Investing in TIPS: Deflation

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 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 under-perform TIPS that are much newer and have almost no accrued inflation. This occurs because of investor concern that accrued inflation could be lost.

If investors get too 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, may be largely removed.

Risk of Investing in TIPS: CPI vs. Your Inflation Rate

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.

This article is part of an email interview with John Hollyer, a former co-manager of the Vanguard Inflation-Protected Securities (VIPSX) fund, where weasked, “What are the primary risks of investing in TIPS?”

See Also: The Difference Between Bonds and Bond Funds

Updated by Kent Thune

Disclaimer: The information on this site is provided for discussion purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.