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
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 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 (
). 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
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.
Changes 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
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%.
One 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
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
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.
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