Treasury Inflation-Protected Securities (TIPS) turned 16 this year and could celebrate an important milestone later this year: $1 trillion in market capitalization.

Their inflation-proofing properties have made them popular in many portfolios, but after the Federal Reserve announced a less accommodative monetary-policy stance in May, they declined more steeply than the broad Treasury market. To address some of the questions we have received from advisors, we turned to Gemma Wright-Casparius of Vanguard Fixed Income Group. Wright-Casparius is the manager of Vanguard’s broad-market TIPS fund and comanages its short-term TIPS fund.

Should I have TIPS in my portfolio, especially given that inflation is low?

“A reason to own TIPS is that you can’t predict what future inflation will be,” Wright-Casparius said. “TIPS offer protection against unexpected inflation, and, while not a perfect match to most consumers’ personal-consumption baskets, they are well correlated to the Consumer Price Index (CPI).” [TIPS ETFs vs. Gold]

She said the current low-inflation environment will not last forever. “The market is pricing inflation at 2 percent over the next ten years. The last ten years it averaged 2.5 percent. If you think inflation will revert to the mean, TIPS will outperform versus nominal Treasuries.” (The rate on a nominal bond is not adjusted for inflation.)

The decision to invest in TIPS is based on a view that future inflation will be higher than market expectations, or a preference for diversifying the risk of higher inflation, or both. The break-even inflation (BEI) rate is the rate of inflation that would give an investor the same return at maturity on both a nominal Treasury security and a TIPS security with an identical maturity. The BEI rate represents not only the bond market’s expectation of future inflation over the life of the bonds but also the risk premiums that reflect the uncertainty about future inflation and the relative liquidity of the two bonds.

If actual inflation is above the BEI rate, TIPS will outperform Treasuries with equivalent maturities. If actual inflation equals BEI, theoretically investors would be indifferent about owning TIPS or nominal Treasuries. If actual inflation is less than the BEI rate, nominal bonds may outperform over the life of the bonds.

“Equities can serve as an inflation hedge, but you still may want to immunize against unexpected shocks in inflation,” Wright-Casparius said. “Some exposure to TIPS can make sense, particularly for many high-net-worth clients and for those seeking to reduce portfolio volatility.”

Have valuations fallen enough to make TIPS attractive?

In recent years declining real yields (nominal yield minus inflation) have led to high returns for the broad TIPS market, which returned an average 8.57% per year for the three years through March 31, 2013, creating a bull market for TIPS that mirrored that of the nominal bond market (TIPS’ returns are represented by the Barclays U.S. Treasury Inflation Protected Securities Index). In the second quarter, however, the broad TIPS market fell 7.05%, more steeply than the broad Treasury market (the Barclays U.S. Treasury Index returned -1.92% in the quarter). The period saw a mixture of rising interest rates and falling inflation expectations, an adverse environment for TIPS.

“Interest rates have risen sharply over the past two months as the market anticipates the unwinding of the Federal Reserve’s quantitative-easing program,” Wright-Casparius said. “TIPS as an asset class have underperformed. However, for those investors who are considering inflation-protection bonds, TIPS may be more attractive because the BEI has fallen to 2 percent from 2.6 percent. The hurdle is much lower for outperformance relative to nominal Treasuries because inflation has to exceed only 2 percent over the next ten years, not 2.6 percent.

“Both TIPS and nominal bonds become more volatile as rates rise, but avoiding both asset classes could mean losing an important diversifier for your portfolio. The asset allocation decision comes down to whether you are making a long-term or short-term commitment.” Longer-term investors can feel more comfortable investing in TIPS, while short-term investors could face downdrafts that could be hard to recover from, she said.

Next page: More on TIPS

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