When inflation remains tame, TIPS can tumble

If you’ve looked carefully at your grocery receipts recently, you may have noticed a rise in the price of some of the items. Inflation appears to be waking up from its almost six-year nap. It rose to 2 percent annually, as measured in July by the Consumer Price Index, and some forecasters expect it to rise still more in the coming months.

So it might appear prudent to protect your investments against that possibility. Enter Treasury inflation-protected securities, or TIPS, a special type of bond introduced by the Treasury Department in 1997. The price of a TIPS bond adjusts for changes in inflation. So when the bond matures, you receive the original price plus additional payments based on the rate of inflation during the life of the bond, as measured by the CPI.

TIPS can protect investors against inflation, but that doesn’t mean that they protect against other risks. Recent history provides an example.

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Just like ordinary bonds, TIPS have a market price that can rise or fall between its issue date and maturity date. In the years after the 2007-2008 recession, investors paid a hefty premium for TIPS. In 2011 they priced them with the expectation that inflation would soon climb to 2.5 percent. But when inflation proved to be tame in 2012 and 2013, prices for TIPS tumbled along with the bond funds that owned them.

As you can see from the worst one-year performance of the funds below (all of which occurred in 2013), even the most consistent TIPS fund performers fell in price.

More recently, the total returns of TIPS and inflation-protected bond funds have returned to more normal levels; the average actively managed inflation-protected bond fund returned 3.8 percent last year. And the most consistent performer, the Vanguard Inflation-Protected Securities fund, is also the least expensive. As we often emphasize, low fund costs are a primary determinant of long-term outperformance.

A relatively new way to invest in TIPS is through exchange-traded funds. Only two ETFs have a track record of at least five years: the iShares TIPS Bond and SPDR Barclays TIPS ETFs. They both own more of the longer-term TIPS than the other four funds in the table below, which tend to own short-term TIPS.

Investors should remember that short-term TIPS, like ordinary bonds, will have less volatility than long-term TIPS funds.—Chris Horymski

This article originally appeared in the September 2014 issue of Consumer Reports Money Adviser.