TIPS Down, but Not Out

Investors who tried to find sanctuary from portfolio-rotting inflation via the TIP exchange-traded fund may be wondering why their fund is falling while inflation keeps rising.

The iShares Lehman TIPS Bond (TIP Quote), which invests solely in Treasury Inflation Protected Securities (TIPS), is down 1.99% so far this year, providing little comfort to those who believed they'd be "protected" as the fund's name suggests.

The downturn comes as rising interest rates create volatility for the TIP ETF's short-term investors. Longer-term holders, however, still may be poised to benefit as rate changes smooth out.

As a whole, the TIPS situation may not be as bad as it appears on the surface, says Matt Tucker, head of product strategy for fixed income at Barclays Global Investors, the firm that birthed the TIP ETF.

This year, the yield on 10-year TIPS has risen to 2.51% from 2.05%, cutting the market value by about 4%. Tucker notes, though, that there are mitigating factors to the bond's faltering prices.

"That's just the price component; there is also the income piece," he says. "There is also the coupon, and investors will also receive an adjustment to principal amount based on changes in inflation."

In addition to a nominal or fixed coupon payment, holders of TIPS also receive extra interest payments that grow in lockstep with changes in the consumer price index. And on top of that, the principal or face value of the bond is increased in line with inflation.

The relationship to the CPI is why some investors with long-term-focused portfolios buy TIPS-type funds as a hedge against the withering effects of a rising price level. It gives investors the security of knowing that at least a portion of their portfolio will keep pace with inflation.

The pain for inflation-fighting fund holders, however, may continue further if the Fed keeps raising short-term rates. The TIPS market, as a whole, is extremely sensitive to changes in interest rates relative to its sensitivity to changes in inflation, says Ken Volpert, senior portfolio manager of (VIPSX Quote)Vanguard Inflation-Protected Securities, a mutual fund that invests in TIPS.