Bill Gross Is Buying TIPS … Should You?

After providing excellent returns during the past four years, Treasury Inflation-Protected Securities (TIPS) have been sluggish so far in 2013.

Using iShares Barclays TIPS Bond Fund (NYSE:TIP) as a proxy, the asset class — which delivered average annual gains of 8.5% in 2009-2012 — is up just 0.10% year-to-date. TIPS have been particularly weak on a relative basis in April, trailing the gains in plain-vanilla Treasuries by a wide margin. While iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT) is ahead 3.8% on the month, TIP is up just 0.17%.

The most important factor in TIPS’ reversal of fortune is the shifting outlook for inflation. Previously, investors were concerned that central bank money-printing would eventually spur increased inflation. But in the past few weeks, the talk has shifted to deflation.

Last week, consumer price inflation (CPI) fell 0.2% at the headline level, while core CPI ticked up 0.1%. The annual rate of inflation is now under 1.5%, which has significantly reduced the demand for inflation-linked assets across the board.

The soft inflation picture has been visible not just in the weakness in TIPS, whose principal adjusts upward in tandem with inflation, but also the collapse in the prices of commodities — particularly gold. Last week, Bloomberg reported that institutional investors are “capitulating” on the inflation trade by dumping TIPS.

Oddly, retail investors are taking the opposite tack: reports that the TIP ETF received the fifth-highest inflows among all ETFs in the week ended April 19, pulling in $349 million. The nine other TIPS ETFs added $103 million of their own, including $27.8 million for FlexShares iBoxx 3-Year Target Duration TIPS (NYSE:TDTT) and $23.3 million for Schwab U.S. TIPs ETF (NYSE:SCHP).

Retail investors who are looking to buy on weakness have some good company: Pimco chief Bill Gross. The “Bond King” hasn’t yet given up on the notion that the aggressive stimulus policies of the world’s central banks will lead to inflation in the coming years.

Last week, Gross pointed to what he believes is the favorable “breakeven rate” between TIPS and plain-vanilla Treasuries. This breakeven point measures the difference between the yield on the 10-year plain-vanilla Treasury note versus the yield on the 10-year TIPS. Since Treasuries need to compensate investors for inflation risk, whereas TIPS do not, comparing the two rates can help gauge the market’s expectation for future inflation.

On Friday, the breakeven reached 2.32 percentage points — near the lowest level since last September. If inflation comes in higher than this level, investors will be better off owning TIPS over traditional Treasuries. Gross expects this to happen, which is why he’s buying TIPS here.

Should You Follow Gross Into TIPS?

Investors who are joining Gross in buying TIPS need to be aware of one important point. Someone — like Gross — who purchases individual TIPS securities would indeed be better off with TIPS over standard Treasuries if inflation exceeds the breakeven rate. However, an investor who accesses the asset class through a fund or ETF such as iShares Barclays TIPS Bond Fund has no such guarantee.

TIPS are rate-sensitive just like Treasuries, so if rates rise, the funds will experience a principal loss that will likely exceed any benefit gained from inflation protection — perhaps by a wide margin.

The chart below shows the close relationship between TIP and iShares Trust Barclays 7-10 Year Treasury Bond Fund (IEF) in the past three years. The takeaway: if IEF reverses course, so will TIP.


If rates begin to rise, it will leave investors in TIPS funds vulnerable. While it’s unlikely the Fed will start wrapping up its quantitative easing policy this year, it will eventually be compelled to wind down the program.

The asset manager AllianceBernstein estimates that 10-year rates are about 1 percentage point lower at present than they would be if Fed policy weren’t a factor, which leaves room for substantial downside in the bond market at some point. While this may not occur until 2015 or even beyond, it still means that the clock is ticking for owners of government bond funds.

Investors who have been pouring cash into TIPS funds during the past week would be wise to keep that in mind.

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