3 Reasons to Avoid Treasury Inflation-Protected Securities

The U.S. government's Treasury inflation-protected securities (TIPS) are a popular addition to most bond portfolios, particularly when the economy isn't performing very well. For many investors, TIPS are an obvious go-to pick whenever there is above-average uncertainty about inflation and market returns. Unfortunately, TIPS rarely live up to their billing, primarily because this is an investment that most people don't understand as well as they should.

Functionally, Treasure inflation-protected securities (TIPS) act a lot like other Treasury bonds. They are backed by the credit of the United States government and they pay annual interest like Treasury bonds. The crucial difference is the face value of a TIPS bond is adjusted according to the official consumer price index (CPI) of the Bureau of Labor Statistics; the higher the CPI, the higher the face value for the TIPS.

On the surface, this seems like a great deal. Inflation eats away at nominal interest payments, so an upward adjustment on face value means the interest payments go up with inflation. However, TIPS aren't the only securities that have inflation priced into their value; standard Treasury bonds also have an implicit inflation adjustment.

If the markets anticipate inflation to be 3% over time, that expectation is priced into the bond market. Investors make decisions based in part on whether they think inflation will be higher or lower than what the price of a security reflects. This affects the value of TIPS and normal Treasury bonds, but TIPS are less likely to win that exchange.

Given this scenario, TIPS are only more likely to perform better than Treasury bonds if the stated CPI is higher than what the market anticipates. The modern CPI is a little prejudiced against high inflation numbers, which means market inflation expectations are often higher than the CPI. The result is a lower real interest rate for TIPS.

The major problem with the contemporary CPI calculation is the Bureau of Labor Statistics intentionally leaves out goods most likely to be affected by inflation. There are also mathematical limitations to the formula that make it difficult to reflect real changes in product accurately.

Three major consumer items are either left out or underreported in the current CPI framework: housing, food and energy prices. Inflation is most likely to occur when excess money is injected into an economy, and these three items are all major destinations for new cash flows. By ignoring food, energy and housing, the CPI can ignore prominent prices that affect everyone. (For related reading, see: Why the Consumer Price Index Is Controversial.)

The CPI might note a container of nails didn't go up in price, but the container might actually have 5% fewer nails than before. Prices are an imperfect measure of shifting quality or quantity, and many producers choose to reduce real output rather than raise prices for their customers.

Some have called TIPS the only risk-free investment because of their principal safety and alleged inflation protection. However, one of the major indicators of risk is price volatility, and TIPS often come up lacking in this department.

For example, consider the standard deviation and average return for the Barclays U.S. Aggregate Bond Index between 2005 and 2015, a historically bad time to be a bond investor. The standard deviation was 3.26%, while annualized returns were 4.75%. It's a little tricky to approximate a TIPS index that investors can buy, but the Vanguard TIPS Fund is pretty close. The TIPS Fund returned 4.2% and had a standard deviation of 6.4% over the same period – more volatility, less return.

This is not to say you should never invest in TIPS, just be aware of their potential shortcomings and understand how they work before adding them to your portfolio. (For related reading, see: Inflation Protected Securities: How They Work.)