Treasury Inflation-Protected Securities

The answer is a resounding yes – there is risk. And I think that the TIPS mutual funds and ETFs are especially risky right now, even though they are very popular. You see them recommended as ‘inflation fighters’ in magazines every month.

(I recommend holding TIPS directly to maturity, no risk in that investment, unless you worry that the Treasury is going to default. You may lose out on some potential interest, but you won’t lose your money.)

Look at this five-year chart of the TIP ETF:

1) We are sitting very close to a 5-year high for this ETF.

2) The base-rate paid on 10-year TIPS is very low, based on history. When that base rate starts rising, TIPS mutual funds will lose value.

3) A more normal value for this fund appears to be around 100, instead of the current 108.61.

This part of the chart is the most interesting:

During the financial crisis of 2008, there was a sudden fear of deflation, meaning negative returns on TIPS. So bond buyers began demanding a premium on the base rate, which was driven from less than 2% before the crisis to about 3.5% at the peak of the crisis.

This peak of fear was a excellent time to buy TIPS and TIPS mutual funds. I bought into Vanguard’s TIPS fund on Dec. 1, 2008 at $11.14. It is now $13.21, a capital return of 18.5%, on top of the interest payments.

You can’t expect returns like that from a TIPS fund — I actually switched out in September 2009 at 12.44, into the Total Bond Fund, which looked a little less risky.

(How did I do on that? Pretty much a wash. Vanguard TIPS (VIPSX) returned 6.17% in 2010, while Total Bond (VBMFX) returned 6.42%.)

The point is … if a TIPS fund can give you capital return of 18% in two years, it can also give you an equal loss. There is risk, and since the base rate is so low right now, I think these TIPS funds are risky.

There’s a whole lot of confusion about TIPS. If you see a TIPS listing, like the one run in Barron’s, you see a rate of return of about 0.9% for a 10-year bond. Why would anyone invest in that? The reason:

The principal of TIPS is adjusted according to the Consumer Price Index. With a rise in the index, or inflation, the principal increases. That means that your principal continues to rise, and therefore will pay more interest, year after year, until maturity.

Could your principal go down? Yes. With a fall in the CPI, or deflation, the principal decreases. And that has happened in recent years, but the adjustments down were minimal.

Why buy TIPS? TIPS are a hedge against inflation, so a 10-year TIPS pays less base interest than a 10-year Treasury note. Right now (April 2011) a 10-year TIPS would be  paying about 0.92%, plus the inflation rate.  A 10-year Treasury note is paying about 3.58%.

So, you should buy TIPS if you believe that over the next 10 years, the U.S. inflation rate will run higher than 2.66% — the difference in the base yields.

If inflation runs at 2.66% over 10 years, the investments are pretty much equal. If inflation is less, you lose with the TIPS. However, if inflation runs higher than 2.66%, let’s say at an average of 4.5%, you are covered with the TIPS if you hold to maturity. That safety is a huge plus, and the reason TIPS make sense for small investors.

Can TIPS lose value on the open market? Yes. If the base rate of a 10-year TIPS climbs back into the 2% range — which is actually very normal rate — your TIPS issued at 0.92% is going to be worth less on the open market. (And that is why TIPS mutual fund investments are less safe.) But if you hold to maturity, that won’t matter, you will get your 0.92%, plus the inflation adjustment.

How do you buy them? You can buy them directly from TreasuryDirect.gov, a very simple process. You can buy them on the secondary market, but I doubt many individual investors do that. And you can buy them in a TIPS mutual fund, but then you won’t be holding the investment to maturity and you face greater principal risk.

When you buy through TreasuryDirect.gov, you are going to be making a ‘noncompetitive bid,’ unless you are a zillionaire or huge investor. With a noncompetitive bid, you agree to accept whatever yield is determined at auction. If you bid this way, you are guaranteed to receive the security you want, in the amount you want.