Monday, October 1, 2012

TIPS Funds, a Risky Bet

This excellent Vanguard article must be read by anyone investing in TIPS (inflation-protected securities) funds. Here's the deal: investing in TIPS funds isn't the same thing as buying TIPS. Differently from bonds, TIPS funds cannot offer nominally-guaranteed payouts at maturity. And TIPS funds have high duration and are significantly affected by TIPS yields (a proxy for expected real interest rates), as seen in this graph (copied from the article):


By historical standards, TIPS yields are extremely low at this point (graph from Vanguard's article):


Meaning that those who invest in TIPS funds today are exposed to high downward risk and low expected rates of returns for a long period of time. The article concludes with a very clear warning:
Considering that the best long-term predictor of bond returns is the starting yield, with TIPS real yields near zero today, the long-term expected real return of TIPS would also be near zero. From a nominal return standpoint, if current break-even rates of inflation between 10-year TIPS and 10-year nominal Treasuries are about 2%–2.5%, adding that inflation expectation to the zero real-return expectation puts the long-term expected nominal return of TIPS at 2%–2.5%, unless there is a significant upward or downward movement in inflation. Those expectations are much lower than past returns... As with most investments, the short-term performance of TIPS, both positive and negative, is an unreliable basis for long-term return expectations. Given the current low-yield environment, the return outlook for TIPS (as with most U.S. bond investments today) is muted and likely to be more volatile than in the past.
In other words, betting on TIPS funds at this point can only be a winning strategy if you believe that real interest rates will continue to fall deeper into negative territory. Given that nominal rates cannot fall further, this is the same as to believe that inflation will rise and central banks won't respond by increasing nominal rates accordingly. Not impossible, given the extent to which central banks have departed from sound monetary principles since before the crisis, but yet extremely improbable, no matter how reckless they have become.

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