The recent pullback in ETFs tracking inflation-protected bonds along with Treasuries is a reminder the funds can be hurt by rising interest rates.

The iShares Barclays TIPS Bond Fund (NYSEArca: TIP) is the largest ETF that invests in Treasury Inflation Protected Securities, holding $22.7 billion in assets.

With TIPS, the yield is based on changes in the Consumer Price Index as well as Treasury yields. [TIPS ETFs: Where’s the Inflation?]

TIPS ETFs “might sound like a great idea on the surface, but they’re a much different animal than holding the bonds themselves,” writes Daniel Putnam at InvestorPlace.

ETFs that invest in TIPS with longer durations have risks that might not be apparent because they are sensitive to interest rates, he said.

For example, TIP has traded lower in August as 10-year Treasury note yields have climbed above 1.8%.

“To understand just how much of a problem this is for TIPS investors, consider the impact on the bond market if inflation were to spike suddenly,” Putnam wrote.

“Given the low level of yields at the present time, any hint that prices are heating up more than expected would lead to a sudden reversal in the ‘flight to quality’ and a rapid steepening of the Treasury yield curve,” he added. “In this scenario, long-dated TIPS would be crushed.”

The concern is that investors bought TIPS for inflation protection without considering the rate risks.

“Despite its inflation protection, fluctuating interest rates still lead to volatility here,” according to a Morningstar analyst report on TIP.

“It is important to note that inflation is just one component of interest rates and that changes in the ‘real rate’ or the risk-free cost of capital will cause the value of TIPS to oscillate up or down just like Treasury bonds,” it said. “Because yields are near all-time lows, even if inflation expectations rise, TIPS bonds are still a low-return investment. Finally, if interest rates rise faster than inflation expectations, then TIPS will still lose value.”

TIP has an effective duration of about 8 years, according to BlackRock.

iShares Barclays TIPS Bond Fund

Full disclosure: Tom Lydon’s clients own TIP.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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