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Investing Specialists

A Split Decision on TIPS

Some readers laud their inflation-protection properties, while others cite low yields and reliance on CPI as reasons to stay away.

Investors are rarely at a loss for risk factors to worry about. Between market risk, interest-rate risk, the risk of a rare "black swan" event such as the financial crisis, and other concerns, investors usually are relieved when there's one less risk to have to consider. So it's been with inflation risk in recent years. The Consumer Price Index, or CPI, the most common measure of inflation, has registered increases of 2.1% or less each year since 2011--low by historical standards and a trend recently given a boost by a plunge in energy prices.

For investors who own or who are considering buying Treasury Inflation-Protected Securities, or TIPS, a widely used hedge against inflation, this prolonged period of low inflation may be cause to question whether doing so makes any sense. After all, as Christine Benz, Morningstar's director of personal finance, points out in this article, TIPS funds offer negative real yields and 3-year returns that are essentially flat (0.4% annually through April 9). Who wants to own an asset that performs like that?

Of course, the counterargument is that this may be just the time to own or start buying TIPS. Morningstar's Bob Johnson sees a growing threat of labor scarcity that could potentially spark higher inflation in the coming years.

With this in mind, we asked Morningstar readers on our Bond Squad discussion board whether they currently own TIPS and why. Answers were more or less evenly split between yes and no, with readers providing compelling reasons for both sides. You can read the full discussion here and excerpts below.

'I Find TIPS Hard to Ignore'
Some readers who own TIPS said they've considered ditching them in light of recent performance and low inflation but are holding on for now. Lionsgate was one.

"I maintain a 5% allocation to TIPS in workplace plans because they're not represented in the total bond market index," lionsgate wrote. "I've considered re-allocating that money due to underperformance but decided to hold on. I wouldn't sell small-cap, real estate, or international holdings due to short-term underperformance, so why sell the TIPS?"

Others emphasized the role that TIPS play in their portfolios, even when the need isn't immediately apparent.

Academic wrote, "I have 5.5% of my portfolio in a TIPS fund. It's mainly for diversification and a hedge against unexpected inflation." 

"I find TIPS hard to ignore as a heavy component of any fixed-income portfolio for the simple reason that keeping up with purchasing power is the biggest risk in fixed-income investing," wrote JohnGalt. "If there's a better option for addressing this risk, I am all ears."

Among readers who have recently begun buying TIPS or TIPS funds was JRinNY, who wrote, "I replaced a short-duration fund in one of my retirement accounts with a real return (TIPS) fund at the end of last year. The allocation is about 3% of my overall portfolio. The reasons for the movement:  I believe that the short-duration bonds will underperform due to the first Fed [interest-rate] move expected by the end of the year. ... Longer duration enables me to use TIPS as a counterweight to other risk in my portfolio, which includes a heavy dose of equity and credit exposure. ... Going forward, I expect TIPS to outperform Treasuries of similar duration. ... As commodity prices stabilize and wage pressures grow throughout the U.S., the under 2% inflation might be history soon."

Another reader, Uysses, described his plans to use TIPS to help him manage retirement account distributions.

"I own some individual TIPS in my IRA," he wrote. "They represent about 10% of my total fixed-income allocation of 35-40% or about 4% of my portfolio. I have intended to add to the TIPS allocation but have been waiting (in vain) for the yields to improve before doing that. I've got something of a ladder so that as the TIPS mature they can be used as 5-10 years of mandatory IRA distributions when I start to take these at age 71. By doing this, I am more comfortable with having more equity investments in the IRA knowing that I probably won't have to sell them at inopportune times to meet minimum distributions. I think TIPS still have a useful role as portfolio 'ballast.'"

Another reader, Tomas47, has a much higher allocation to TIPS.

He said, "I have a short-term TIPS fund representing 25% of my fixed-income allocation. For the usual reasons--high-quality ballast for the overall portfolio with inflation protection. I tilt the balance of my bonds to corporates to offset the low nominal yield of TIPS. I also have a modest allocation to REITs that may or may not offer inflation protection."

'Inflation Should Remain Very Low'
While there was plenty of support for holding TIPS these days, they had their detractors as well.

In response to our question asking readers whether they own TIPS, marcos wrote, "Absolutely not. ... The vaunted inflation-hedge benefits are eclipsed by the interest-rate risk, with currently abysmal yields."

Low yields were also cited by reader AndrewXnn as a reason to avoid TIPS.

He wrote, "The way I look at 10-year TIPS is if they are yielding over 3%, that means they are cheap. When they are yielding around 2% that's fair. When they are yielding less than 1% [as they currently are], that's expensive and anything less than 0% is just plain silly and only true financial engineers would ever be able to find relative value in them."

For capecod, there simply are better ways to hedge against inflation.

"I don't currently own TIPS because 1) unique among insurance products, TIPS will be cheaper to purchase after inflation has actually arrived and 2) currently higher-yielding [inflation-]hedged portfolios generate distributable cash flows at rates so much higher than TIPS that unless inflation explodes to at least high single digits almost immediately, TIPS cannot provide competitive (and inflation-compensating) cash flows or total returns over any intermediate investment horizon."  

In some cases, readers said they have no interest in TIPS simply because they are not concerned about inflation.

For example, KTInvesting wrote, "It's been hard for the U.S. economy to get traction in spite of all the cheap cash the Fed funneled into the mix. There isn't the demand and it's demand that reignites inflation. I don't see this changing any time soon."

Several of those saying they do not own TIPS brought up current monetary policy in the U.S. and other countries as a primary reason inflation doesn't worry them--for now, at least.

"With just about every nation on earth devaluing their currency--a currency race to the bottom--it's hard to envision an inflation scenario," wrote ACynic. "As imports get cheaper (due to currency effects) and thus competition increase[es], combined with what appears to be lackluster demand for goods/services/commodities, inflation should remain very low."

One reader, mckinm, said that, if anything, it's deflation that should be a concern.

"I had a small position in TIPS and sold it three or so years ago. I don't like them," the commenter wrote. "It's hard to imagine them being a useful hedge anytime soon in the current environment. The entire world seems to be printing money now and it smells like deflation, not inflation."

Mckinm and others also took issue with the inflation-adjustment method used by TIPS, in which the principal increases or decreases based on changes in the CPI.

Some agreed with Tony123, who wrote, "The CPI is a government-generated number that measures inflation for food, education, medical bills, durable goods, clothing, etc. It is a long list of items that the typical American family would own, be it a want or need. The items that have gone up the most (food, medicine, insurance, fuel) for families are kept at a small proportion to the whole picture. In short, I feel that the CPI is a doctored number that does not reflect the true measure of inflation."

'I See No Benefit for Us'
Then, there were those who said they don't own TIPS simply because they get inflation protection elsewhere in their portfolio.

"I see no benefit for us," said BoomerGuy. "My pensions and Social Security are inflation-protected (to some extent). My investments give me a goodly interest/dividend yield plus pretty nice capital gains. Unless we return to the awful '70s inflation numbers, I just don't see a reason to own them. Plus, if we returned to such inflation numbers, I would be buying high-interest U.S. Treasuries, not TIPS."

Jomil wrote, "I have never owned TIPS or [inflation-protected] I Bonds because I never felt a need for them while working, with annual raises, or now in retirement, with the majority of my income coming from sources that include an inflation[-adjustment] component. I do not expect to own them in the future unless rates increase substantially, and probably not even then." 

Some comments have been edited for clarity and brevity.