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When you think of controversy these days, things like Heath Care Reform and the war in Afghanistan probably come to mind. What likely doesn’t top the list are TIPS (Treasury Inflation Protected Securities). But among two well regarded investing authors, there is a debate brewing over whether we could experience rising interest rates in a deflationary economy, and what impact such a perfect storm would have on an investment in TIPS. And the debate has turned a bit nasty. Here’s what happened.

Unlike a traditional bond, TIPS protect investors from inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

Author Rick Ferri published an article entitled, The Dark Side of TIPS, on the Forbes website. If you’ve never heard of Rick, he is the author of several excellent investing books:

I’ve interviewed Ferri before and found him to be a very practical investor who does a good job at making complex investing topics easy to understand.

In his article about TIPS, Ferri notes that interest rates could rise even with little or no inflation. This may seem odd at first, as inflation and interest rates tend to be highly correlated. But as Ferri points out, interest rates could go up if our trading partners lose confidence in the dollar. To attract investors to U.S. bonds, we’d have to raise interest rates. At the same time, however, inflation could remain low due to actions by the Fed and an aging population that consumes less. In Ferri’s words:

The risk is a loss of confidence by our trading partners who hold trillions of dollars in U.S. Treasury bonds. If our trading partners decide not to buy our newly issued bonds, or worse, decide to sell the bonds they currently hold, the supply of U.S. government debt washing around the global financial system will increase exponentially. Selling may beget selling as one country tries to dump ahead of others. The only way to make U.S. debt attractive again is for real interest rates to go up substantially to match the level of perceived risk in U.S. obligation. That is the big risk for TIPS investors.

The key point is this: Real interest rate increases are not the same as inflation-based interest rate increases. Bond yields are composed of two interest rates; the anticipated inflation rate and a real interest rate over inflation. These two rates can move in opposite directions. For example, assume a nominal 30-year Treasury bond has a 4% yield based on a 1% anticipated inflation rate and a 3% real yield. If foreign investors lose faith in the U.S. and start selling Treasury securities, and at the same time inflation falls to zero, the 30-year Treasury bond could rise to 5% with no inflation. A jump in the real interest rate presents a big problem for inflation indexed bond holders because neither their par value nor interest income will increase because there is no inflation adjustment.

A rise in real interest rates that coincides with low or disinflation (lower inflation) is an inflation-indexed bond holder’s bad dream. They would be stuck with low income from their TIPS, no increase in TIPS par value, and lower TIPS prices as bonds react to higher real rates. A nightmare scenario would occur if real rates increased from foreign selling and simultaneous deflation (negative inflation) in the U.S. This would cause TIPS prices to cascade downward due to deflation adjustments downward in par values and interest income and at the same time react to falling bond prices because real rates are rising.

Ferri’s not suggesting that you avoid TIPS, but it’s fair to say he wouldn’t recommend putting all of your bond investments in inflation-protected securities. Ok, fair enough–so where’s the debate?

Enter Larry Swedroe. Swedroe is an accomplished investing author in his own right. I’ve read Wise Investing Made Simple: Larry Swedroe’s Tales to Enrich Your Future (Focused Investor), and he has also penned:

In an article entitled, Do TIPS Have a Dark Side?, he takes aim at Ferri’s perspective. The article was published on a Money Watch blog run by CBS. Ferri apparently responded to Swedroe’s points in the comments to the article, but then somebody at CBS deleted Ferri’s comment. Oh, the intrigue!

Now, I think debate is healthy. We need to voice disagreements about money. It’s how we learn, and it helps us think through the issues to come to the best decisions for our own finances. Having practiced law now for almost twenty years, however, I can tell you that Swedroe’s article read more like a legal brief, attacking Ferri’s article point by point. If you are interested, you can read both articles and draw your own conclusions. For our purposes, however, two points Swedroe made in his article need to be addressed.

First, Swedroe claims that TIPS act as a hedge against deflation:

TIPS hedge deflation even better than inflation, because they can’t mature below par. Consider an investor who purchases a 10-year 2 percent TIPS at par and experiences cumulative deflation of 20 percent over the life of the bond. Because the bond matures at par, the real return won’t be 2 percent, but approximately 4 percent. Even if a bond is purchased above par, there’s no risk from deflation in terms of real returns (the only kind that matter).

This is just flat out wrong. Swedroe is correct, of course, that if you hold TIPS to maturity, you’ll be paid no less than par value (the amount you invested). But that’s true of all bonds; it’s not an added feature of TIPS. More importantly, in a deflationary economy, TIPS investors will be paid interest on a principal amount that is reduced by the amount of deflation as measured by the CPI. In contrast, non-inflation indexed bonds pay interest on the amount of the investment. As a result, TIPS do not hedge against deflation.

Second, Swedroe cited with approval an article suggesting that investors would do well to sink all of their bond exposure into TIPS. While Swedroe would not be the first to make this recommendation, I take issue with it for a few reasons.

First, like equities, our bond investments need exposure to bonds in other currencies. I think it is a mistake to but all of your bond investments in U.S. denominated bonds. Second, the protection that TIPS give us against inflation comes at a price. The government isn’t stupid (well, not in this case, anyway). There are times when the yield on TIPS makes them very attractive as compared to other government bonds. But generally the interest rate on TIPS will reflect (i.e., be lower) the added exposure the government is assuming by agreeing to index the bonds to inflation.

As a result, I spread my bond investments across TIPS, non-inflation protected U.S. government bonds, and foreign bonds. You could add to this mix high yield (i.e., junk bonds) bonds, but I don’t.

So what’s your take, should investors have more than just TIPS in their bond portfolio?

Author Bio

Total Articles: 1077
Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Article comments

Allerton D. Marshall says:

I disagree with DR, and think that Swedroe is absolutely correct. When you purchase a new TIP you are locking in a real return for the term of the bond. This is exactly why we purchase TIP’s – for the assurance of a predictable real return, which protects us from inflation, at least in the CPI index. If there happens to be net deflation over the term of the note, congratulations! You just received a windfall bonus! But the promised real return is still a floor protecting the purchasing power of your investment.

DR says:

Allerton, my question for you is this–what advantages do TIPS provide investors during deflationary periods that non-inflation indexed bonds don’t provide? The windfall bonus you describe would apply to non-inflation indexed bonds, too (would it not?), AND you would not have to suffer through reduced interest payments as you would with TIPS if the CPI goes down.

Dave says:

I also agree with DR. There is no one who can predict with any 100% accuracy where interest rates or equites will be in the future. Lucky guesses? Sure. Even a stopped clock is right twice a day as the saying goes. Only gamblers and speculators will bet it all on a single stock or bond. Just ask those who had all their 401(k) money in Enron stock. Like DR, I choose to have a portion of my bonds in TIPS. And a portion in government, municipal and foreign bonds, through mutual funds. Instead of hitting home runs, I’ll hit singles and make my way around the bases that way.

Edwin says:

One problem I have with what Swedroe says is that the only returns that matter are real returns. I don’t see how he can just ignore nominal returns. As a quick example, if the inflation rate is 3% and you are only earning 2%, you are losing wealth. Sure you aren’t actually losing money but you are losing the purchasing power of that money because it doesn’t keep up with the CPI.

More on topic, I’ve never been a fan of investment strategies that involve sticking with just one thing rather than diversifying so I’d have to side with DR and say that it’s better to invest in a variety of bonds.