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Why TIPS Won't Protect Against Rising Rates

Inflation protection, not interest-rate defense, is their mission.

If there's one thing that every Treasury Inflation-Protected Securities fund investor should know, it's this: TIPS do not offer guaranteed protection from interest-rate risk.

Confusing TIPS' inflation-hedging ability with an ability to fight off interest-rate volatility is a wholly understandable error that investors have been making since TIPS first hit the U.S. market in the late 1990s. As much as they are linked to each other, though, inflation and interest rates are not the same thing.

Before we look at why that's so important, here's a quick refresher on the difference between regular, or nominal, Treasury bonds and TIPS. Like regular Treasury bonds, TIPS are issued with a face, or par, value of $1,000. And also like regular Treasury bonds, they distribute coupon, or interest, payments that are expressed as an annual percentage rate of the par value.

Attacking the Boogeyman
One of the key problems with regular Treasuries, of course, is inflation. If a Treasury bond's coupon payment is 5% and inflation is 2%, then the so-called real yield is actually only 3%. Of course, the age-old problem with that setup is that the investor is taking a chance that the coupon payment, which is fixed over the life of the bond, won't keep up with a surge in inflation. If inflation in this example turns out to be 3% instead of 2%, it will eat right into your real yield.

Enter TIPS. Instead of leaving to chance the question of how much of a Treasury bond's return will be eaten up by inflation, TIPS instead promise investors that their principal value will rise in lockstep with the Consumer Price Index. That guarantees investors' principal will keep up with inflation, and because TIPS' coupon payments, which are just the real yield, are still calculated as a percentage of that principal amount, their value can move up with inflation as well.

So, why is it that, if their principal values are linked to CPI, TIPS are still sensitive to interest-rate shifts? Interest rates and inflation rates don't have to move in unison. Just like a regular Treasury bond, a TIPS' price is also affected by how much income--in this case, the real yield--it's going to throw off over the course of its existence. So, if nominal Treasury yields rise because inflation spikes, TIPS are protected. But if nominal yields are driven higher because of rising real yields, TIPS are much more vulnerable.

If you look at the mathematically calculated duration of a TIPS portfolio or index, you're likely to see a number that looks pretty long. Say you've got one with a six-year duration, implying that for a 1% rise in market yields, you would expect the portfolio's price to fall by 6%. That number only has meaning with respect to changes in real yields, though, not nominal Treasury bond yields and not inflation. And most of the time, changes in real yields aren't as sharp or as large as they are for regular Treasury bonds. That's why, in the early years of the TIPS market, it was common to hear that TIPS were roughly 25% to 40% as volatile as regular Treasuries.

We're Not in the 1990s Anymore, Dorothy
The decade of the 1990s was a different time, though, and one during which real yields were much higher, typically between 3.5% and 4%. In those days, the TIPS market wasn't as large or as actively traded, and real yields didn't move all that much. Today, however, real yields are down in the 1.5% range, in part because so many people have purchased TIPS for their inflation protection, thus driving their prices up and their real yields down. In fact, 2009 was the biggest yet for inflows to TIPS focused funds, with more than $18 billion flowing into the category.

It's crucial to understand that if real yields for nominal Treasuries and other securities do rise broadly at some point, they will begin to provide a more generous alternative to investors than the 1.5% currently being paid by TIPS. That's just another way of saying that in order for TIPS to remain competitive, their real yields will likely have to go up too. What will that mean for TIPS' prices? As noted earlier, if you have a TIPS portfolio with a duration of six years and real yields rise 1%, then you'd expect that portfolio to suffer a 6% loss. A 2% change in yields would imply a 12% loss.

Do any of these percentages call into question the case for owning TIPS as a long-term inflation hedge? The answer is not at all. It does, however, argue that one shouldn't confuse TIPS with a hedge against day-to-day interest-rate volatility. That is one thing they definitely are not.