Interest in Treasury Inflation Protected Securities (TIPS) is surging as investors seek protection against both inflation and deflation. Even Yale endowment manager David Swensen, in an interview conducted in late May, recommended TIPS, saying they offer unique advantages under a broad range of economic scenarios.
For U.S.-based investors seeking protection for retirement assets, there is no better investment than TIPS. Retirees can park their assets in TIPS and, if their account is large enough, maintain their standard of living on an inflation-protected basis.
But TIPS are not without risks, and those risks are typically not well understood by investors. TIPS, as we will see, are among the most volatile of fixed-income securities.
TIPS, which were introduced to the U.S. market in 1997, guarantee a real rate of return to the investor. They carry a coupon rate and, each month, the principal value of the security is adjusted based on changes in the CPI-U, either up if there is inflation or down if there is deflation. Payments on TIPS are calculated by multiplying the coupon times the adjusted principal value.
The principal value of TIPS is protected at par at maturity. In a deflationary period, the principal value may go below par, reducing interest payments to investors, but at maturity the investor is guaranteed payment of the full principal value at par.
TIPS represent a relatively small portion of the U.S. Treasury market, with $14 billion issued in the second quarter of 2009 as compared with $327.5 billion in nominal bonds.
Boston University Professor Zvie Bodie argues that TIPS are the safest inflation hedge for a U.S. dollar-based investor and are arguably the safest investment in the market today–period. All other traditional inflation hedges may work as a hedge, but will introduce other risk factors. TIPS, on the other hand, are a pure inflation hedge.
If real interest rates are stable, TIPS will trade near their accrued principal value. But real interest rates have been relatively unstable, and TIPS prices have fluctuated substantially. The chart below shows the market price (in red) and accrued principal value (in blue) for a 30-year TIPS issued on 4/15/98.
The market price fluctuated between 89.3 and 135, with a range of more than 30 points in 2008. Although the price is above the principal value roughly as long as it is below this value, the volatility is substantial.
The culprit behind this volatility is the long duration of TIPS. Duration is a measure of the sensitivity of a bond's price to changes in interest rates; bonds with longer duration have greater price changes in response to a given change in interest rates. Duration increases for bonds with cash flows farther in the future. Because TIPS have a substantial principal payment at maturity, they have long durations.
