The role of bonds in our clients’ portfolios — especially today with extremely low yields — is that of a shock absorber. It’s no guarantee, but bonds generally react very differently than stocks to economic or political surprises, whether it’s news in Greece or an economic slowdown here in the US.
To realize this diversification benefit of holding bonds, the bonds held must be of very high quality, otherwise some of the shock absorption feature is lost. The two types of bonds that we primarily consider are US Treasury bonds and US TIPS bonds. Let’s discuss TIPS today.
TIPS stands for Treasury Inflation-Protected Securities. The primary difference from a standard Treasury bond is that TIPS are set up to track inflation. If inflation goes up, TIPS will pay its investors a higher return. This feature makes TIPS a popular option for investors who want to protect their portfolio against unexpectedly high inflation.
Before you get too excited, you should know that just like any other interest rate, today’s yields on TIPS are extremely low. 10-year TIPS bonds currently pay just 0.5% per year over inflation. Not really something to brag about.
Although not too exciting, TIPS along with standard Treasury bonds do play an important role when building a properly diversified portfolio. How much you hold will depend primarily on how risky you want your overall portfolio to be.
And as with other asset classes, I typically use index funds or ETFs that hold dozens of bonds instead of buying individual bonds directly. Unlike other asset classes, buying individual TIPS bonds is not impractical for individual investors, so it could be the better option in some cases.
Here are some of my basic requirements when selecting an investment for any asset class:
- Asset class purity. How well does it represent the asset class I’m looking for?
- Cost. Besides the expense ratio, the turnover ratio is another factor to consider, as trading incurs transaction costs and capital gains taxes.
- Fund management. ETFs and index funds come and go, so stick with managers with a track record of managing these types of investments.
The following is a list of notable funds that track TIPS bonds. For investors looking for TIPS in fund form, this is the place to start.
|Fund Size ($MM)
|Net Expense Ratio
|Schwab US TIPS ETF
|Fidelity Spartan Infl-Prot Bd Idx FidAd
|Vanguard Inflation-Protected Secs Adm
|Largest, cheapest index fund
|Schwab Treasury Infl Protected Secs Idx
|iShares TIPS Bond
|Largest, most traded ETF
- Fund size of at least $250MM
- Net expense ratio of 0.25% or less
- Minimum initial investment of $50,000 or less
- Average effective duration between 5 and 10
- Available to the public without an advisor