One side benefit of establishing even a small stake in the Fidelity Inflation-Protected Bond Fund (FINPX) is getting Fidelity’s annual and semiannual shareholder reports. The managers of this fund – William Irving and Franco Castagliuolo – seem to be straight shooters. They have been unusually frank in the past two years about the risks building in TIPS mutual funds as yields sank negative to inflation over much of the maturity ladder.

Those risks became reality in May 2013 when TIPS yields began rising from extremely low levels, slamming holders of TIPS mutual funds with about an 8% loss for the year so far, at a time of very low inflation and thus, very low income from the fund.

Here is how the Fidelity Inflation-Protected Bond Fund has performed this year against the Fidelity Total Bond Fund (FTBFX):

So that’s the backdrop for Fidelity’s current semiannual report, dated Sept. 30, 2013. It opens with a message from Abigail Johnson, Fidelity’s chairman, about the overall bond  market and prospects for higher interest rates:

As 2014 approaches, the Fed once again appears unsure about the sustainability of U.S. economic expansion. Policymakers continue to grapple with the difficult task of balancing the ongoing need for economic support with their desire to begin the process of normalizing monetary policy. While the associated uncertainty may result in further bond market volatility in coming months, we haven’t yet seen economic conditions that would justify dramatically higher interest rates. That said, we believe the global economy is recovering, slowly but surely. Over time, the recovery should drive interest rates higher, offering bond investors the opportunity to reinvest at higher rates.

Then comes a Q&A with the FINPX managers, Irving and Castagliuolo, which I am reproducing here in its entirety:

Q. Bill, how did the fund perform?

W.I. For the six months ending September 30, 2013, its Retail Class shares returned -6.58%, while the Barclays® U.S. Treasury Inflation-Protected Securities (TIPS) Index (Series-L) — which tracks the types of securities in which the fund invests — returned -6.40%. To provide a sense of how the fund performed relative to its competitors during the period, the Lipper^SM Treasury Inflation-Protected Securities Funds Average returned -5.76%. For the 12-month period ending September 30, 2013, the fund’s Retail Class shares returned -6.44%, the Barclays index returned -6.10% and the Lipper peer group average returned -5.51%.

Q. Why did TIPS perform so poorly during the six-month period?

W.I. Simply put, interest rates rose and inflation expectations diminished. In May, the U.S. Federal Reserve signaled it could begin scaling back its purchases of Treasury and government-backed mortgage securities, triggering a steep sell-off of government bonds — including TIPS — in May and June. At the same time, inflation expectations receded because investors believed the Fed was set to decrease its support of the economy even though growth was still weak — a potentially deflationary move. TIPS ended the period on a better note, when the Fed surprised most market observers in September with its decision to refrain from tapering its stimulative bond-buying program.

Q. Turning to you, Franco, what was your investment approach?

F.C. Throughout the six-month period, we adhered to our investment mandate, investing virtually all of the fund’s assets in TIPS with maturities ranging from one to 30 years. This helps explain why the fund trailed its Lipper peer group average. Many funds in our peer group were focused solely on the better-performing short-term TIPS, which helped them significantly outperform those with a broader mandate to invest in the entire TIPS market. We kept the fund’s risk profile similar to that of the Barclays index by maintaining interest rate sensitivity that was about in line with the benchmark. Additionally, our yield-curve positioning — how our holdings were invested in TIPS across the maturity spectrum — was similar to that of the benchmark. We also looked for ways to add incremental return through security selection. Various factors — including which part of a given year a TIP security was issued — can result in mispricing, and we sought to take advantage of those inefficiencies by purchasing only securities we believed to be attractively priced and selling those we felt were fully valued. After accounting for expenses, these strategies helped the fund keep pace with the Barclays index during the six-month period. And while the fund, like the TIPS market itself, experienced significant outflows, they occurred at a consistent pace and, as such, had generally no impact on the fund’s absolute or relative performance.

Q. What’s ahead for the TIPS market?

W.I. At the end of the period, there was a lot of negative sentiment weighing on the U.S. government bond market, including TIPS. In our view, we are not in a secular bear market. We believe that higher interest rates would likely choke economic growth. Furthermore, inflation has remained benign and the Fed seems to be skittish about pulling away its monetary stimulus. Without significant economic growth or inflation, and with a central bank that appears willing to continue to buy bonds, we don’t think the case for a secular bear market holds much credibility.

F.C. Given that outlook, we believe that TIPS offered investors reasonably priced inflation protection at the end of the period. While our best case scenario doesn’t forecast a significant rise in inflation over the foreseeable future, there’s the possibility that the Fed has been too pessimistic in its economic outlook and that inflation ratchets higher.