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Bond Alert: Investing “TIPS” are for the Birds

Well, let’s just say that “the Bernank” didn’t disappoint… and in the aftermath I bet more than a few Monday-morning quarterbacks were hunkered around water coolers in offices worldwide dispensing investment advice.

Just remember: Don’t invest on water cooler tips. I’ve rarely seen one that worked out.

Some investors and “tipsters” are unhappy with the message Bernanke delivered. It may seem like he left a lot to the imagination.

And unfortunately, when the market lets its mind wander, it often overreacts – sometimes in the wrong direction.

And so do the tipsters…

Needless to say, a stock market selloff was kind of predictable – the Fed has been hinting at ending QE for some time…

Nevertheless, the bond market reacted poorly. Yields have already been rising and are expected to spike when (or if) bond prices crash.

Some prognosticators think inflation is coming – in a big way…

And there’s one type of bond that you might have in your portfolio because you were told “you gotta have it” at the water cooler because “it’ll protect you from inflation.”

But if things don’t work out just right, that bond could end up giving you a double whammy of trouble.

Let’s take a look at Treasury Inflation-Protected Securities (TIPS)…

The TIPS of the Iceberg?

Barron’s published an article on TIPS two Saturdays ago, which probably shocked a lot of investors…

It was a warning for investors about the risks of TIPS.

You see, no matter how well-researched an investor might be, sometimes what once seemed like an ideal investment proves to be just the opposite.

And TIPS are the subject of a lot of scrutiny these days.

Issued by the U.S. treasury, TIPS have two components – 1) they pay interest, and 2) their value is adjusted higher based upon the rate of inflation.

And that’s the double whammy – in order for you to truly benefit from TIPS, inflation needs to be rising and interest rates should be stable or in decline (but not rising).

For the past six months, TIPS have been dropping in value…

For one, because rates are rising. And, two, because of anticipation that the Fed will “taper” its massive bond-buying program, sending prices lower. (Which Mr. Bernanke kinda-sorta-might’ve conceded to…)

So… Where’s the Inflation?

Of course, substantive inflation has been absent in the midst of the current snail-like “recovery.”

Even the most optimistic predictions for economic growth over the next few years include an outlook for inflation to be fairly tame.

So with the Fed apparently intent on curtailing its bond-buying, the presumption must be that bond prices will continue to fall and yields will rise.

And with low inflation, TIPS owners might just find the intended benefit of those securities as scarce as water in a desert.

It’s a quandary. So, what to do, what to do?

One thing investors could do is to establish a hedge against a long TIPS position. More aggressive, dare I say “speculative” investors, on the other hand, could just go short on TIPS.

The ProShares UltraShort TIPS ETF (TPS) is an ideal fund for executing either strategy…

The fund is designed to deliver the inverse performance of TIPS, including ETFs like the iShares Barclays TIPS Bond Fund (TIP).

As individual TIPS, or ETFs like TIP decline, TPS will rise.

As a hedge, owning TPS could neutralize losses in TIP while the dividend – currently about 2.75% – keeps on paying.

Naturally, there are divergent perspectives out there regarding TIPS.

Some think they’ve never lived up to the hype, while others think much higher inflation is coming and that TIPS are must-own securities.

But in the end, I think it’s more practical not to look at what might be but what is

And that’s low inflation coupled with rising interest rates and declining bond prices. In other words, (more) disaster for TIPS owners.

Safe investing,

Steve Gunn