Why You Still Need TIPS

Treasury inflation-protected securities are the go-to income investments if you want to protect principal from the ravages of inflation. But there’s a problem: TIPS can lose money and can do so surprisingly quickly.

The downside of TIPS came to light over the spring and early summer, when global credit markets sank in response to suggestions by the Federal Reserve that it might cut back its easy-money policies. TIPS tumbled, too. From May 2 through June 24, a Barclays index of U.S. TIPS with maturities of at least one year plunged 9%.

How they work. Introduced in the 1990s, TIPS are Treasury bonds that are linked to the consumer price index. Interest is paid twice a year, and the bonds’ principal value increases with inflation and decreases with deflation. When the bond matures, you receive either the inflation-adjusted principal plus interest or, in the event of deflation, the original principal plus interest.

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In recent years, investors have poured money into TIPS and other Treasury bonds as a hedge against turmoil in Europe and other parts of the world. Investors also worried that the Fed’s massive bond-buying program would spark inflation. Because of the strong demand, TIPS prices rose, and their yields, which move in the opposite direction, turned negative. (A negative TIPS yield means your return will be less than the change in consumer prices.)

But when chairman Ben Bernanke suggested that the Fed might soon back away from its bond purchases, the fixed-income market—including TIPS—went into a tizzy. Not only did investors flee TIPS under the threat of higher rates, but inflation was nowhere to be found, a terrible combination for TIPS holders.

Some good news did come out of the bond rout. As prices fell, yields on ten-year TIPS became positive for the first time in a year and a half. As of August 2, the real, or inflation-adjusted, yield on ten-year TIPS is 0.42%. That means if you were to buy a ten-year TIPS today, your annual return over the holding period would be roughly the inflation rate plus 0.42 percentage point.

So are TIPS bargains now? To see whether TIPS make sense, experts look at the so-called break-even rate. That’s the difference between yields on TIPS and yields on regular Treasuries, recently 2.6 percentage points on bonds with ten-year maturities. Annual inflation would have to average more than 2.6% for investors to earn more on TIPS than they would on regular Treasuries. Over the past year through June, consumer prices climbed 1.8%, but inflation has averaged about 3% annually for most of the past century.

Most investors should hold TIPS. Think of them as a way of hedging against future erosion of your purchasing power—with some volatility along the way, to be sure, but with less volatility than many other inflation hedges, such as gold.

Morningstar analyst Michelle Canavan suggests investing in TIPS with short maturities, which are less sensitive to rising rates than TIPS with long maturities. Consider Vanguard Short-Term Inflation-Protected Securities Index Fund (symbol VTAPX), which was launched last October, or its exchange-traded sibling, which trades under the symbol VTIP. Both versions show a current negative yield of about 1%. Year-to-date through August 2, the mutual fund version lost 1.1%. Expenses are just 0.10% per year.

Funds and ETFs offer convenience, but if you want a guarantee that you’ll get your principal back at ma­turity, you can buy TIPS directly from Uncle Sam without commission at www.treasurydirect.gov. TIPS are sold in maturities of five, ten and 30 years; the minimum purchase is $100.

You don’t have to rush into TIPS. But if you’re investing for the long haul, keep in mind that although inflation has been mild and may stay low for a while, it rarely disappears entirely.