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Inflation protection: Worth the price?

TIPS funds can lose money too

Consumer Reports Money Adviser: May 2014

Most investors opening their statements last year would have been pleased. U.S. stock indexes were up more than 30 percent in 2013, and even some international stocks gained despite endless headwinds. And even though bond funds lost some value, as expected, most lost no more than 1 percent, nothing that should disturb a long-term investor.

But there’s a subset of bonds that has been clobbered in 2013. TIPS, or Treasury Inflation-Protected Securities, lost more than 7 percent of their value in 2013, according to the Morningstar bond index that tracks them. Most TIPS funds still report negative 1-year returns.

TIPS are a special type of bond issued by the Treasury Department that have grown in popularity since their introduction in 1997. Unlike ordinary bonds, where the Treasury returns the original purchase price to the current bondholder, the price of a TIPS bond adjusts for changes in inflation as measured by the Consumer Price Index. So instead of $1,000, the owner of a 10-year TIPS bond that matured in July 2013 received $1,267, which included the 10 years of inflation adjustments since 2003.

 

Not Bulletproof

 

How could such a seemingly solid investment, one that promises to keep up with inflation, do so poorly? Part of the answer lies in a market that has paid increasingly larger premiums for this investment. From 2011 until early 2013 the market has priced TIPS expecting a 2.5 percent inflation rate during the next 10 years.

That may sound modest, but consider how little inflation we’ve actually experienced in the last five years. Despite the billions of dollars the Federal Reserve has injected into the market through various monetary policies, its attempt to get inflation up to 2 percent has fallen short of the target. In 2013 the annual core inflation rate, as measured by the PCE inflation measure the Fed currently uses, ranged from 0.8 to 1.4 percent.

Now the market has readjusted its opinion, and TIPS currently reflect 2 percent inflation. Is that rate still too high—or low? Time will tell. But one thing that investors can learn is that TIPS aren’t a bulletproof investment. On the contrary, as their name suggests, they play a very useful but specific role. Think of them as insurance against inflation. Buy some, but not more than you need.

 


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