Watch Out for TIPS

Whenever someone tells you that an investment is a no-brainer, watch your wallet. Ten years ago, for example, investing in index funds that track Standard & Poor’s 500-stock index looked like a sure thing. But those funds made little money over the subsequent decade and ranked behind 80% of all stock funds.

Today, many advisers are touting Treasury inflation-protected securities as a can’t-miss investment for safety-conscious investors. TIPS, which are backed by the U.S. government, offer a guaranteed return above the inflation rate. They pay interest at a fixed rate twice a year. The principal, or face value, of the bonds rises with inflation and declines in the rare event that consumer prices fall. When TIPS mature, holders receive an amount that has been adjusted for changes in consumer prices during that period, but investors cannot receive less than 100% of the principal amount when the bonds were first issued.

If inflation surges in the coming years, as some investors believe it will, TIPS are guaranteed to increase in value right along with the consumer price index. What could be better?

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Here’s the catch: TIPS behave like any other kind of Treasury bond. As such, they are subject to interest-rate risk. Bond prices and rates move in opposite directions. So, if rates rise, TIPS prices will fall.

If you buy TIPS directly and hold them to maturity, this isn’t a problem. When the bond expires, you’ll get back your principal plus the adjustments for inflation. For example, if today you buy TIPS that mature in five years, you get a measly “real” yield of 0.1%. You’ll get that amount of interest plus the inflation adjustments. If you buy a ten-year TIPS, you’ll get a real yield of 1.3%.You certainly won’t get rich with TIPS, and you must hold your TIPS to maturity to avoid any chance of losses.

But if you invest in TIPS through a mutual fund or exchange-traded fund, rising rates can be a serious problem. Because funds generally don’t mature and are constantly trading bonds, they typically lose money when rates rise.

Consider Vanguard Inflation-Protected Securities (symbol VIPSX). The fund is a member of the Kiplinger 25 and is perhaps the best in its category. It returned an annualized 6.4% over the past ten years through February 4. But between October 25 and February 4, as the rise in Treasury-bond yields began to accelerate, the fund lost 4.8%.

The fund has an average duration of 5.3 years. That means that if interest rates on similar securities rise by one percentage point, the fund should lose about 5.3%.

Let’s add up the numbers. The Vanguard TIPS fund currently yields 0.23%. If inflation, as measured by the CPI, matches the 2010 rate of 1.5%, the fund’s value will be adjusted upward by 1.5 percentage points. That suggests that the fund will produce interest income to the tune of 1.73% for the year. But if interest rates rise just one percentage point, the fund’s net asset value should decline roughly 5.3%, for a net loss of 3.57%.

If interest rates and inflation soar, TIPS won’t perform nearly as badly as ordinary Treasury bonds. That’s because the value of TIPS will be adjusted upward as the consumer price index rises. But inflation and interest rates tend to move in sync. So the likelihood is that TIPS will gain value with rising inflation and simultaneously lose value with rising interest rates. “You could have rising inflation and negative returns with TIPS, which is exactly what I think will happen this year,” says Kenneth Volpert, head of taxable bonds at Vanguard. “I think we’ll have pretty bad returns for regular Treasuries and for TIPS,” says Volpert.

Frankly, with a 12-month rise of 1.5% in the CPI, I think it’s premature to worry about a resurgence in inflation, especially because increases in food and energy prices account for much of that increase. The Federal Reserve Board is still much more worried about high unemployment, which tends to depress inflation. (Kiplinger forecasts that consumer prices will rise about 2% this year.)

But if you really believe inflation is about to take off, stocks could be a better bet. Historically, they have provided a good hedge against inflation, particularly stocks of companies that have the power to raise prices in an inflationary environment.

Stocks of commodities, such as those found in T. Rowe Price New Era (PRNEX), are worth consideration. New Era has most of its assets in energy stocks, but also owns companies that mine for precious metals, as well as fertilizer companies, which benefit from the rising cost of food. Vanguard Energy (VGENX) is a good choice for a pure energy play.

As for bonds, this is a time to keep your maturities short. Don’t be fooled into buying long-term Treasury bonds -- even if they are TIPS.

Steve Goldberg (bio) is an investment adviser in the Washington, D.C., area.