TIPS have become the Rodney Dangerfield in retirement circles: They are getting no respect.
That’s because TIPS—Treasury Inflation-Protected Securities—have produced disappointing returns in recent years. In contrast to regular Treasurys that carry no inflation protection, and which have been steady—if unspectacular—performers over the last five years, TIPS have struggled to not lose money.
Many retirees therefore are giving up on TIPS in favor of regular Treasurys. Before you do so as well, however, you need to understand what TIPS can offer. I say that because many of the criticisms of TIPS reflect a fundamental misunderstanding.
In essence, TIPS provides insurance against unexpectedly high inflation. Since the last five years have experienced just the opposite—unexpectedly low inflation—it’s hardly a surprise that they haven’t provided eye-popping returns. But that’s not a criticism. After all, you wouldn’t cancel your homeowners’ insurance just because there hasn’t been a fire.
TIPS, to review, are Treasury bonds whose principal is guaranteed to grow with inflation. Their coupon reflects the interest that the bonds pay on the adjusted principal amount. Currently, for example, a TIPS with a 5-year maturity trade is yielding 0.5%, which means that if you hold it until maturity you will make 0.5% above and beyond whatever the inflation rate is over the next five years. (Another way of saying the same thing: Your real return over the next five years will be 0.5%.)
The TIPS’ price between now and its maturity date will fluctuate according to whether inflation turns out to be higher or lower than expected. Currently, for example, a regular Treasury security with a 5-year maturity yields 2.2%, which is 1.7% above the yield of comparable TIPS. This difference, known as the break-even rate, reflects the market’s collective expectation of the CPI’s annualized rate of growth over the next five years. If inflation comes in significantly higher, then TIPS will likely rally—and vice versa.
This helps to explain why TIPS have been disappointing performers over the last five years. In contrast to a breakeven inflation rate of 2.1% at the end of 2012, actual inflation since then (as measured by the CPI) has been 1.4% annualized. Note carefully, however, that even though TIPS over the last five years didn’t produce impressive returns in their own right, retirees gained something valuable in the process: Their entire portfolio’s inflation-adjusted value deteriorated at a far slower pace than previously expected.
Put this way, I don’t think any of us should be particularly upset—particularly retirees.
That’s because inflation to them poses a particular threat, since fixed income investments represent a large portion of their portfolios. Inflation is especially toxic to bonds that are not inflation protected, because it both leads to higher interest rates (which cause them to fall in value) and cuts into the purchasing power of their principal.
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The bottom line: TIPS aren’t a good bet if you think inflation will stay lower for the foreseeable future. But if you want insurance against the risk that it will rise significantly in coming years, then you might want to give TIPS a second chance. A typical recommended allocation to TIPS is around a quarter to a third of your total bond exposure.
For most retirees, the best way to gain TIPS exposure is by investing in a mutual fund or exchange-traded fund that invests in them. Two low-cost alternatives are the Vanguard Inflation Protected Securities Fund VIPSX, +0.23% with an average maturity of around 8 years, and the Vanguard ST Inflation-Protected Securities Fund VTIPX, +0.04% with an average maturity of around 3 years.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email [email protected].