TIPS Down, but Not Out

Changes in interest rates have eight times more negative impact on the price of the inflation-protected bond than equivalent changes in inflation, he explains. For example, a one percentage point increase in interest rates would lead to an 8% drop in the price of a TIP, while a 1% jump in inflation would result only in a 1% increase in the principal value of the TIPS bond.

"The most important thing for investors to understand about TIPS and TIPS funds is that they're not immune to price volatility," says Eric Jacobson, senior analyst at Morningstar. Over time, he notes, the growth in the value of TIPS funds will converge with that of the CPI, but in the short term, investor demand and interest rates play a factor.

Specialty mutual funds that invest in TIPS have seen the value of their investments retreat by an average of 2.14% this year, according to data from mutual fund watchdog Morningstar, with the worst, the (IPBBX)Wells Fargo Advantage Inflation Protection Bond fund, down 2.9%.

"All the major economies are tightening, and there are a lot of negatives that require real interest rates to go up," says Volpert. "The best environment [for TIPS] would be when real interest rates are declining."

Along those lines, investors holding on to TIPS funds for the long term could likely see their losses reverse when the Fed eventually lowers interest rates.

"For the vast majority of clients, their time horizons are measured in five- to 10-year increments," says Paul Winter, head of Five Seasons Financial Planning in Salt Lake City. "When someone complains [about performance], we always go back to basics," and discuss personal goals such as when the client will need to cash out his investment.

Winter is a fan of the Vanguard fund because the fund has a particularly low expense ratio of 0.2%. The average inflation-protected bond fund has an expense ratio of around 1.0%. Like the Vanguard fund, the iShares TIPS ETF also has an expense ratio of 0.2%.

Winter also likes Treasury Direct as a way for individuals to get such exposure to the investment class. Treasury Direct allows investors to purchase U.S. bonds, including TIPS, straight from the U.S. Treasury, and eliminate any third parties and the fund expenses. Such transactions can be executed over the Internet.

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