Inflation protected securities

Question: I am enthusiastic about your recommendation to make TIPs a core investment. I appreciate this advice along with many other recommendations of yours during the years. All of my TIPs are in an IRA. Consequently, the TIPs are held in a mutual fund. Is your recommendation for TIPs as strong even when they are held in a mutual fund? Thank you. John, Brookfield, WI

Answer: Yes, I think owning Treasury Inflation Protected Securities or TIPS in a bond fund works as a hedge against inflation. Professor Zvi Bodie of Boston University is the leading proponent of the TIPS as a core investment for retirement savings. (I'm also a huge fan of his and I've learned a lot interviewing him over the years.) He notes that owning the bonds directly gives you greater control over the timing of when you receive your inflation-hedged cash. You're also agnostic to fluctuations in market value if you own the actual bonds and hold them to maturity. (When a bond matures you get your underlying investment back. So, if you bought a $1,000 bond with a 10 year maturity you'll get your $1,000 back in 10 years.) However, the way the U.S. Treasury rules are currently written you can't buy TIPS directly from the government for your IRA or comparable retirement savings account. You must use a broker or middleman. It's still a worthwhile cost of ownership since the commissions attached to buying U.S. Treasuries are typically very low.

Nevertheless, for many of us buying TIPS through a mutual fund is convenient. Many employer-sponsored retirement savings plans only give us the option of a mutual fund that invests in inflation-protected securities. The portfolio will be volatile reflecting changes in the market and the outlook for inflation. Since the mutual fund doesn't have a specific maturity date you're never quite sure what the payoff on your investment will be in the future. But the mutual fund TIPS investment offers a hedge against inflation.

By the way, the latest issue of the Journal of Financial Planning has an illuminating interview with Bodie on TIPS, the returns to equities, his thoughts on run-of-the-mill investment advice, and other topics. You can read it here.

About the author

Chris Farrell is the economics editor of Marketplace Money.
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This is bad advice. Chris is confusing convenience with utility. A TIPS mutual fund is not guaranteed to protect against inflation at all for the same reasons Chris writes. It all depends on when you buy and when you sell.

When you buy a TIPS mutual fund you are paying market price for the bonds which has factored in inflation expectation for each bond in its duration. So in theory, if nothing else changed and inflation changed as expected, then the return from that bond would be zero for inflation risk (but will have a return for other factors such as interest rates). So it will not hedge against inflation at all (as TIPS).

Similarly when you sell, you get a price that has factored in the inflation expectation for the future for the bonds in the fund. If that is low at that time, then you will get a negative return for taking on inflation risk meanwhile and this is true even if inflation has increased while you are holding the bond fund!

So, the only time it will act as an inflation edge is when you buy the fund at a time when the inflation expectations are low and sell it a time when the inflation expectations are high and may or may not be correlated with actual inflation to act as a hedge.

Megan, your complaint does not make sense to me. As I understand it, TIPS aren't sold with a fixed inflation expectation. Rather the principle is adjusted to reflect inflation twice a year. A TIPS bond fund has the same interest rate risk as any other other bond fund (that rising interest rates will reduce the value of the fund), but it seems TIPS funds do hedge for inflation better. I'm not a finance expert though, so I'd be interested in a more detailed explanation, especially how the fixed rate of the bond is affected by expected inflation. In the end though, the difference between a bond fund and your own bond ladder seems to be liquidity and the management expense.

The best way to get the benefit of TIPS is to buy them from Treasury Direct, at auction, and then to hold them until maturity. I believe that Megan is correct in her appraisal of the risks of TIPS Mutual Funds. You can buy them direct from Treasury Direct or in an IRA through your financial institution. For instance, at Fidelity you can buy them online with no fee. If you use their Bond reps to purchase TIPS on your behalf it costs $20. For tax purposes TIPS are best purchased in IRAs because taxes on the dividends are deferred. I-bonds are best if you're buying them outside of an IRA. Taxes aren't due on the earnings/dividends until the bond matures.

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