I had the pleasure of conducting an email interview with Vanguard Principal John Hollyer, co-manager of Vanguard Inflation-Protected Securities Fund. In this interview, John sheds some light, from an expert's perspective, on the benefits and the risks of owning TIPS.
What are the benefits of including TIPS in your portfolio?
There are two main benefits of TIPS bonds. The most unique features of TIPS are that they're essentially a Treasury (Treasuries dominate the U.S. dollar market for TIPS), and secondly they're indexed to inflation, so two of the key risks for bond investors -- credit/default risk and inflation risk -- are addressed by these securities. I characterize them as the long-term, risk-free rate. These bonds are free of those two risks, and that gives them some interesting properties. The mitigation of inflation risk through indexation causes them not to trade in lock-step with other bonds.
If we pull back for a minute into a portfolio context, we have an asset like inflation-indexed bonds that have expected returns not that much different than long-term treasury bonds, but a pattern of returns that will be somewhat different. Therefore, they can be a diversifying asset less correlated with the bond market, and help to reduce the overall volatility of the portfolio.
First Benefit of TIPS according to Vanguard's John Hollyer
So in a portfolio context, they have that volatility, diversification, risk-reduction, benefit. It's not as strong today as it was in the late 90s and early part of the 2000s, when they were first introduced. One of the reasons for that is that in the latter part of the last decade, inflation expectations were pretty low and stable, so most of the interest rate change we saw was real rate change and that causes TIPS to move more in lock step with other bonds. But, generally, their correlation with other bonds is less than 1.
Second Benefit of TIPS according to Vanguard's John Hollyer
The second benefit is inflation insurance. Inflation is relatively low right now (2010) -- 2-2.5%, if breakeven is implied, in TIPS. You can buy that insurance against inflation at a relatively low price. With all the monetary and fiscal policy stimulus that is being applied, there are plenty of investors who have chosen to buy TIPS and essentially get that insurance against the idea that there is an inflationary result of all this policy stimulus that's going on.