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May 29, 2009

More on TIPS

Yesterday, I linked to an article warning about the pitfalls of I-Bonds and reiterated that we think TIPS are a better way to add inflation protection to your bond portfolio. But that's not quite the end of the story.

Today, the Wall Street Journal points out the fact that TIPS mutual funds may not be as great an inflation hedge as you might expect. This is somewhat speculative, as TIPS are only about a decade old, and there hasn't been a period of significantly rising inflation during their brief life. So nobody knows exactly how they will behave. But that doesn't mean we can't make educated guesses, which is what this article does.

I encourage you to read the whole article, but in a nutshell, here's the deal. When you buy an individual TIPS bond, you get a fixed interest rate plus an adjustment for inflation. If you hold the bond to maturity, you get your full principal back. Pretty straightforward. The only moving component is the inflation adjustment, which moves up or down based actual measured inflation.

When you buy a TIPS fund however, you're buying a pool of TIPS bonds that have all manner of different maturity dates. Those individual bonds go up and down in value each day, primarily based on what interest rates are doing. In other words, with a TIPS fund, you introduce the impact of daily valuation changes into the equation, whereas when you buy a TIPS bond and hold it to maturity, there are no valuation changes. The individual TIPS bond is only going to fluctuate based on inflation changes, whereas the fund is going to fluctuate based on inflation changes as well as interest rate changes (which impact the demand for those bonds).

Here's how one expert interviewed for the article sums up these factors:

Anne Lester, a senior portfolio manager at J.P. Morgan Funds, has looked at how TIPS fit in a portfolio as an inflation hedge. During an inflation surge, she says, interest rates would be a negative for their prices. However, demand for TIPS likely would grow, supporting prices. Putting it all together, she says, TIPS would likely be a good shield against inflation, “but less inflation protection than you want.”
Ms. Lester’s group identified another set of circumstances that could lead to losses in TIPS: interest rates rising but inflation falling. Between July 1980 and July 1981, interest rates rose to about 15% from 10% while the CPI fell to 10% from 14%. The result: a“perfect storm” that could have sent TIPS down by about 20%.

Note that those hypothetical losses would impact TIPS fund holders, but not holders of individual TIPS who simply hold on to maturity. Those changes in value would apply if they were to sell their individual TIPS at that time, but could be avoided by holding to maturity, at which point their full principal would be returned.

SMI has typically focused on buying TIPS funds, primarily because it's so much easier for most investors. There are several good ones around, like Vanguard's VIPSX. But this does introduce a question regarding whether at least some investors might be better served going through the aggravation of buying individual TIPS bonds instead. They can be purchased through TreasuryDirect.

I'm not totally persuaded that everyone needs to suddenly quit using TIPS funds and start buying individual TIPS instead. The trade-off between maximum benefit and ease-of-use isn't completely settled in my mind. But it does make me think we'll need to ponder this "individual TIPS vs. TIPS funds" issue a bit more.

Bottom-line, we do think beginning to shift from traditional bonds to TIPS makes sense. TIPS are currently priced as if future inflation will remain low for many years. As you know if you've been reading recent SMI material, we too feel that deflation (rather than inflation) is the immediate threat. But we're also pretty convinced that as economic activity begins to pick back up eventually, so will inflationary pressures. If so, having switched from traditional bonds to TIPS (when they were priced for deflation) should pay off.