- September 2016 update: Investors should know: TIPS ETFs and mutual funds are riskier than you think
Treasury Inflation-Protected Securities are a super-safe and super-conservative investment, right? That’s true if you buy and hold TIPS to maturity. I think it’s OK to say there is zero risk of default. You might not beat inflation after taxes, and you might miss out on other investing opportunities, but you will always get all your money back at maturity.
But investing in TIPS mutual funds and ETFs do carry risks, because the net asset value of those funds rises and falls in reverse correlation to the interest rate paid by the underlying securities. In 2012, with the base interest rates of TIPS issues near all-time lows, TIPS values have soared to near all-time highs. If those rates reverse, TIPS values will decline and so will the net asset value of the ETFs and mutual funds.
So there is risk, especially at a time of super low interest rates.
But how much risk?
I am going to try to draw a picture with charts. First, take a look of at the one-year performance of the iShares TIP ETF:
That is an impressive move upward – a gain of 10.5% in net asset value since last February. The all-time high for this fund is $119.38, about 34 cents above where it is trading today. This fund was up 13.4% in calendar year 2011.
That chart might lead you to think the TIP ETF is ‘volatile’ — but actually is isn’t. It has a reported ‘effective’ duration of 4.24, which is fairly low. (See the comments section below for updated information.) The performance was caused by a mighty drop in Treasury interest rates, not by volatility. For evidence, take a look at this next chart:
As you can see, long-term Treasuries were tracking close to TIPS until August 2011, just before the Federal Reserve began ‘Operation Twist’ to drive down long-term interest rates. The Fed action sent the value of long-term Treasuries soaring, and holders of the TLT ETF (Barclays 20+ Year Treasury Bond Fund) ended up with a 33.6% gain in 2011. This fund has a duration of 16.6. That is the definition of ‘volatile’ and TLT is therefore much riskier than the tamer, shorter-duration TIP ETF.
Now I am going to add a couple of popular TIPS mutual funds to this chart, Vanguard Inflation-Protected Securities Fund (VIPIX, duration 8.5) and Fidelity Inflation-Protected Bond (FINPX, duration 6.7):
Interesting … despite some differences in duration, these three funds tracked very closely, all rising about 10% in the last year.
Finally, I am going to drop the volatile long-term Treasuries from the chart, along with the two TIPS mutual funds that track close to TIP, and add IEI (the intermediate-term Treasuries ETF, duration 4.45) and Vanguard’s Total Bond Market Fund (VBMFX, duration 5.0):
I think the ultra-low Treasury rates, across all maturities, are driving investors to TIPS because these investments are protected against a sudden rise in inflation. And with that flood of money into TIPS comes risk. They have outpaced the overall intermediate Treasury market, and the overall bond market. When interest rates begin to rise — when, who knows? — TIPS could suffer a deeper-than-expected drop as investors pour out of TIPS and into more conventional bonds, CDs and money markets.
That is the risk that buyers of TIPS ETFs and mutual funds face, even if the fund appears on paper low-risk and rather tame.