‘Safe’ inflation-fighting funds KO’d by rising rates


When investments are billed as risk-free, that’s usually a good time to put away your wallet.

In recent years, Treasury Inflation Protected Securities have been promoted as the ultimate safe haven because they provide a built-in hedge against inflation. The bonds are backed by the full faith and credit of the U.S. government, and asset managers have introduced many funds that invest in TIPS.

Central bank money printing has also attracted investors worried about potential inflation and a loss of the purchasing power of their dollars. However, loose monetary policies haven’t triggered the runaway inflation predicted by many doomsayers after the financial crisis.

Furthermore, the interest-rate risks of TIPS funds may not have been clearly understood by investors. The iShares TIPS Bond ETF (TIP) and other funds that invest in inflation-indexed bonds have been hit by rising Treasury yields this year.

TIP has a weighted average maturity of about 8.5 years, and the fund’s longer duration means it’s sensitive to rates. The $13.9 billion fund is down more than 6% year to date and has experienced net outflows of over $7 billion.

TIPS funds have been slammed by a double-whammy of rising interest rates and subdued inflation expectations. The magnitude of losses in funds in the $93 billion TIPS category has surprised a lot of investors, according to a recent Wall Street Journal report.

“It’s not a particularly good environment for TIPS,” said Charles Sizemore, who manages the Strategic Growth Allocation portfolio on Covestor.

He expects inflation to remain subdued as markets and economies recover from the biggest debt bubble in history. Consumers are still deleveraging and wary of taking on new debt. Demographics are a headwind on prices as aging baby boomers are downsizing, spending less and saving more, Sizemore added.

TIPS adjust their principal and payouts based on changes in the Consumer Price Index (CPI).  The Labor Department said the 12-month inflation rate fell to 1.2% in September from 1.5% the previous month.  Inflation is below the Federal Reserve’s targeted range of 2% to 2.5%.

Many investors turned to TIPS instead of commodities as an inflation hedge after the credit crisis.

In the three years ended June 30, 2012, TIPS mutual funds garnered about $42 billion in net cash flow, which represented just under 50% of the net cash flow received by TIPS funds in the ten years through June 2012, according to Vanguard.

TIPS funds benefited from falling Treasury yields during that period, which may have fueled further demand. In fact, TIPS sold at negative yields during auctions earlier this year, illustrating the strong demand for inflation protection. However, investors in TIPS funds have lost money this year as interest rates rose and inflation remained calm.

The bottom line for investors is to clearly understand how an investment works before jumping in. Trendy sectors should raise even more red flags.

Photo Credit: Terra Nova Fondation