Swedroe: Understanding TIPS

December 07, 2018

TIPS Misconceptions

Before closing, I’ll take the opportunity to dispel a few misconceptions I hear about TIPS.

One common objection I hear to buying TIPS is that short-term bonds provide a better way to mitigate inflation risk. Unfortunately, this is true only of longer-term bonds. Short-term bonds don’t hedge inflation risk as well as TIPS, and the comparison is not even close. The reason is that when inflation rises, the yields on short-term bonds do not immediately respond to the change in expectations.

Consider the following example. For the period 1933 through 1951, one-month Treasury bills produced negative real returns in all but three of those 19 years and an annualized real return of -3.2%. Beginning in 2002, we have seen a repeat performance, with one-month, three-month and one-year Treasuries producing negative real returns in all but three (2006-2008) of the following 16 years. The annualized real returns over that 16-year period for one-month, three-month and one-year Treasuries were -0.9%, -0.9% and -0.4%, respectively. And that was with a Consumer Price Index of just 2.1%.

Another common objection I hear to buying TIPS involves the expectation that real rates must rise. Thus, an investment in TIPS will suffer. First, investors—including the once-acclaimed “Bond King” Bill Gross—have been forecasting rising rates for quite a while, and they have been dead wrong. That forecast cost them dearly, as they lost an opportunity to earn the term premium, and rates first fell further.

In addition, they have remained at historically low levels for far longer than anyone had expected. However, the issue is basically irrelevant because, if you are confident that real rates are going to rise, you can simply buy short-term TIPS and avoid, or minimize, the term risk.

There are now even short-term TIPS ETFs, such as the PIMCO 1-5 Year U.S. TIPS Index ETF (STPZ), with an average maturity of about just three years, and the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), with an average maturity of about just 2 1/2 years, available for investors who don’t wish to buy individual securities (which can be purchased for any maturity).

Of course, investors considering this alternative (as opposed to buying individual bonds) need to consider not only the expense ratio of the ETF but their trading costs (bid/offer spread and commissions).

Another important point to consider is that, if the market also expects real rates to rise, that expectation already will be reflected in the yield curve. Therefore, staying short only helps if rates rise more than is already anticipated by the market. Not understanding this relationship is a common and costly mistake made by investors and advisors—along with the error of thinking they can forecast rates better than the market.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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