Although I’m not a huge fan of TIPS mutual funds, I own a small stake in the Fidelity Inflation-Protected Bond Fund (FINPX) and I appreciate the candor that comes in each annual and semi-annual report from the fund’s managers, William Irving and Franco Castagliuolo.

Well before the steep decline in TIPS values in 2013, Irving and Castagliuolo were noting the risks building in the soaring TIPS market and ultra-low yields. The threat hit home in mid-2013, when TIPS yields began rising about 100 basis points, hitting TIPS mutual funds hard. FINPX returned -6.93% for the year ending March 31, 2014.

This chart shows how FINPX has underperformed Fidelity’s Total Bond Market fund over the last 12 months, despite the recovery in TIPS prices in 2014:

So today, has 2013’s decline brought TIPS funds back into the ‘safety zone’? Here is the discussion from Irving and Castagliuolo printed in the fund’s annual report, dated March 31, 2014:

Q. Bill, how did the fund perform?

W.I. For the 12 months ending March 31, 2014, its Retail Class shares returned -6.93%, 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 -6.49%. The Lipper Treasury Inflation-Protected Securities Funds Average returned -5.81%.

Q. Why did TIPS perform so poorly?

W.I. Simply put, interest rates rose and inflation did not. TIPS suffered steep losses from May through December 2013 after the U.S. Federal Reserve signaled it would eventually begin scaling back its purchases of Treasury and government-backed mortgage securities. Investors pushed bond yields higher and bond prices lower in response. Inflation ran well short of the central bank’s 2% annual target rate during that span, calming inflation worries and cooling investors’ appetite for inflation-protected securities. In fact, the TIPS market experienced some of its largest investor outflows since its inception in 1997. But TIPS enjoyed a bit of a rebound in the first three months of 2014. Slower-than-expected economic growth, instability in emerging markets and investors’ growing comfort with the Fed’s tapering of its bond purchases helped bolster demand for bonds in general. TIPS further benefited from growing demand as rising energy prices and signs of wage growth rekindled inflation worries among some investors.

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

F.C. We adhered to our investment mandate, investing virtually all of the fund’s assets in TIPS with maturities ranging from one to 30 years. That helps explain why the fund trailed its Lipper peer group average. Many funds in the peer group were focused solely on the better-performing short-term TIPS, which helped them to significantly outperform those like our fund with its 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 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 looked for ways to add incremental return through security selection. Various factors, including when a TIP security was issued, can result in mispricing. We sought to take advantage of those inefficiencies by purchasing securities we believed to be undervalued and selling those we felt were fully valued. After accounting for expenses, these strategies helped the fund keep pace with the Barclays index. And while the fund, like the TIPS market itself, experienced significant outflows, they occurred at a consistent pace and, therefore, had generally no impact on the fund’s absolute or relative performance.

Q. What’s ahead for the TIPS market?

W.I. We expect TIPS to post very modest — and possibly negative — returns during the next 12 months or so. The future return of TIPS can be decomposed into three components: starting real yields, price appreciation/depreciation from the real yield, and inflation. The real yield of the fund’s benchmark was roughly 0.50% at the end of the period, which is a fairly low starting point. We expect real yields to rise from here as the Fed continues to pull back its purchases of government bonds. Since bond yields move opposite their prices, bonds — including TIPS — could experience price depreciation. That said, we believe rates will rise more slowly in 2014 than they did in 2013, given our view that anything more would do material harm to the economy.

F.C. As for inflation, one of the most important questions is whether there is still significant slack in the labor market. We think there is. The unemployment rate stood at 6.7% at the end of the period, slightly more than one percentage point above the Fed’s forecast for the longer-run normal unemployment rate. We believe there is additional slack from people working part time for economic reasons and from people doing a job for which they are over-qualified. This “shadow” labor supply should help keep a lid on wage inflation and overall consumer inflation, which we expect to run below 2% during the coming year.