Why Are TIPS Losing Value?

The world's largest bond fund, the PIMCO Total Return Bond Fund (Nasdaq:PTTRX) fell 2.5% in June and had record outflows of $9.9 billion.

Instead of bailing on Treasury Inflation Protected Securities or TIPS, the manager, Bill Gross, has been backing up the truck on expectations of higher inflation. But it hasn't happened.

Let's examine how TIPS work and why they are losing value.

TIPS 101TIPS first hit the market in the late 1990s and are government-issued fixed-income securities that are backed by the full faith and credit of the U.S. government for timely payment of interest and principal. (As a side note, TIPS issued by foreign governments (NYSEARCA:GTIP) also exist.)

In the case of U.S. TIPS, the bond or note's face value is adjusted monthly according to the rate of inflation as measured by the U.S. consumer price index (CPI). A real yield is applied to the adjusted principal to hedge the investor against inflationary spikes. The CPI is a yardstick of the prices paid by urban consumers for a basket of goods and services.

From May 2012 to May 2013, the Consumer Price Index for All Urban Consumers (CPI-U) increased 1.4% before seasonal adjustments.

While the CPI is one way to gauge inflation, it's far from a perfect measurement. Retirees, for instance, spend a greater portion of their money on medical costs versus the typical American represented in the CPI. Nevertheless, the CPI-U is still a widely used benchmark of inflation and consumer prices.

Calculating LossesChanges in inflation and interest rates do not always move in lockstep with each other. And just like conventional Treasury bonds (NYSEARCA:TLT), TIPS are impacted by movements in the interest rate marketplace.

If Treasury yields increase because of rising inflation, TIPS are hedged. But if yields increase because of rising real yields, as we have right now, TIPS are susceptible to losses.

The largest U.S. TIPS ETF, the iShares Barclays TIPS Bond Fund (NYSEARCA:TIP) has fallen 8.17% over the past three months. How much further can TIPS decline?

The average duration of TIPS owned by TIP is 8.36 years, which implies losses of 8.36% if real yields rise by 1%. And a 2%-3% spike in rates would likely mean losses between 17%-26%.

Hedging TIPSOne way to hedge against falling TIPS prices is to stick with shorter dated maturing notes of less than five years.

Because TIPS with shorter maturities are less impacted by rising rates versus longer maturing bonds, funds like thePIMCO 1-5 Year U.S. TIPS Index Fund (NYSEARCA:STPZ) have lost less value. STPZ is down just 2.39% over the past three months compared to a loss of 8.17% for TIP.

Shorter-dated TIPS, like the kind that STPZ owns, have historically shown a significantly higher correlation with current inflation and lower volatility relative to an index that covers the entire TIPS maturity spectrum. The fund's benchmark is the Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index.

Another way to hedge against falling prices in TIPS is to buy put options on an existing TIPS ETF position. As the TIPS decline, the losses are offset by gains in the value of the protective puts.

For traders or investors that want to capitalize on falling TIPS but aren't comfortable trading options, see the the ProShares UltraShort TIPS Fund (NYSEARCA:TPS). The fund uses 200% daily opposite leverage to TIPS and is designed to increase in value when TIPS prices fall. Over the past three months, TPS has surged 17%.

In summary, as the real yields on Treasuries and other fixed income investments broadly rise, they offer a more generous alternative to the 1.63% yield currently paid by broadly diversified TIPS ETFs. So unless inflation goes higher, all you get with TIPS is lots of interest rate risk. The ETF Profit Strategy Newsletter is published monthly and comes with Weekly ETF Picks along with a Technical Forecast. Since the beginning of the year, 78% of our Weekly Picks have turned a profit and a 525% gain was our biggest winner.