Don’t Thumb Your Nose at Low-Yield TIPS

Many financial advisers consider TIPS (Treasury Inflation-Protected Securities) to be the safest investment there is. So why did a recent auction of the government bonds sell at a negative yield for only the second time in history?

Because TIPS are a hedge against inflation, and plenty of investors fear the Federal Reserve’s unconventional plans to stimulate the economy will one day touch off sharply rising prices. In that case, TIPS will offer protection and returns you can bank on.

TIPS have a unique property that fixed-income investors love. They’re Treasury bonds backed by the full faith and credit of the U.S. government, but twice a year their principal, or face value, moves 1-to-1 with inflation as measured by the Consumer Price Index (not seasonally adjusted).

Creditors hate inflation because rising prices erode the real value of the money they’re owed. With TIPS, the real (or inflation-adjusted) return is known. If held to maturity, the bondholder is guaranteed his principal back no matter what prices do — plus a bit of interest.

That’s what has been driving demand for TIPS, sending their prices up and their yields way down. (Bond prices and yields move in opposite directions.) And that also explains how the Treasury could sell $13 billion in 10-year TIPS at a negative yield of -0.089% last week.

Mihir Worah, a managing director and portfolio manager at PIMCO, offers a hypothetical example illustrating how a current negative yield on TIPS would deliver better returns than a benchmark 10-year Treasury with a higher yield:

“If inflation for the next 10 years averages 3% and the nominal (non-inflation-adjusted) 10-year Treasury yield is 2%, then the real return on nominal 10-year Treasuries could end up being -1%, significantly lower than that offered by comparable maturity TIPS — recently yielding -0.20%.”

With interest rates already offering paltry returns, many fixed-income investors probably scoff at negative yield. After all, at that rate the lender is actually paying the Treasury for the privilege of borrowing her money.

But a number of bond strategists say TIPS still deserve a place in your fixed-income portfolio. True, the Barclays TIPS index is up just 0.8% for the year-to-date versus an 11% gain for the S&P 500. But over the past 12 months, the TIPS index added 12.4% against a much more volatile 7.8% rise in the broader market.

If bonds are the ballast in your properly allocated equity and debt portfolio, then TIPS are the ballast in your bonds, notes Peter Demirali, managing director and portfolio manager at Cumberland Advisors.

“With … potentially significant headwinds (energy prices, Europe, U.S. fiscal policy) Cumberland continues to maintain a longer-than-benchmark duration on our taxable fixed income accounts,” Demirali writes in a new note to clients. Cumberland likes TIPS to keep pace with a rising CPI and anchor the short end of a barbell strategy, in which shorter-duration and longer-duration bonds are favored.

Larry Swedroe, director of research for The Buckingham Family of Financial Services, suggests investors might find it prudent to limit TIPS maturities to 10 years and perhaps 13 years at most, given that TIPS yields are still well below their historic averages.

If you’re a conservative investor, are looking to add ballast to you fixed-income holdings or are worried about sharply rising prices, TIPS make sense despite lousy current yields.

“Given all the unconventional policy measures at work in the markets, we believe it is advisable to invest in something with a known hedge to inflation,” Worah writes.

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