Investors in TIPS Funds Might Face a Rude Awakening

by Daniel Putnam | August 16, 2012 11:15 am

Exchange-traded funds that invest in Treasury Inflation Protected Securities, or TIPS, might sound like a great idea on the surface, but they’re a much different animal than holding the bonds themselves.

TIPS’ built-in inflation-protection feature allows the bonds’ principal to adjust upward along with CPI, providing a guaranteed real return. For investors who buy an individual bond and hold it to maturity, TIPS will indeed work as intended. But for those who invest in TIPS via mutual funds or ETFs such as the iShares Barclays TIPS Bond Fund (NYSE:TIP[1]), Schwab U.S. TIPS ETF (NYSE:SCHP[2]), or any of the nine other ETFs that invest in the space, the risks are greater than they appear.

Here’s why: TIPS are highly sensitive to moves in prevailing interest rates.

For Exhibit A, consider the performance of the TIP ETF in the past three weeks. From July 24 through Aug. 15, the yield on the 10-year Treasury note surged from 1.40% to 1.81%. TIP held up well against rising rates for the first few days of the move, but the ETF has lost 2% of its value since the beginning of the month.

That might not sound like much, but with the last three inflation reports showing year-over-year gains in the 1.4% to 1.7% range, it doesn’t take a substantial capital loss to offset the protection feature that’s built into the fund’s underlying holdings. Still, investors might be complacent following gains of 11%-plus in TIP in three of the past five calendar years.

To understand just how much of a problem this is for TIPS investors, consider the impact on the bond market if inflation were to spike suddenly. Given the low level of yields at the present time, any hint that prices are heating up more than expected would lead to a sudden reversal in the “flight to quality” and a rapid steepening of the Treasury yield curve.

In this scenario, long-dated TIPS would be crushed. While the impact would be less severe on short-dated TIPS ETFs, such as Barclays 0-5 Year TIPS Bond Fund (NYSE:STIP[3]) and PIMCO 1-5 Year U.S. TIPS Index Fund (NYSE:STPZ[4]), the effect on the iShares Barclays TIPS Bond Fund would be significant.

In this sense, the fund actually provides the opposite of what many investors might expect: Rather than inflation protection, it is in fact extremely inflation-sensitive because of its nearly perfect negative correlation with Treasury yields.

The only reason to hold this fund is therefore as a play on interest rates, but on this front, there are a number of higher-beta options, such as iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT[5]) and the various double- and triple-leveraged bond funds.

The challenges faced by the iShares Barclays TIPS Bond ETF might take a while to play out. So far, the countless predictions of rising rates have been well off the mark, and the recent move in Treasuries might prove to be just a replay of the short-term spike that occurred in March.

Still, the events of the past few weeks serve as a warning to the lack of true inflation protection provided by TIPS ETFs.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. TIP: http://studio-5.financialcontent.com/investplace/quote?Symbol=TIP
  2. SCHP: http://studio-5.financialcontent.com/investplace/quote?Symbol=SCHP
  3. STIP: http://studio-5.financialcontent.com/investplace/quote?Symbol=STIP
  4. STPZ: http://studio-5.financialcontent.com/investplace/quote?Symbol=STPZ
  5. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT

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