Forget TIPs: No Need for Inflation-Protected Bonds

08/17/2017 2:50 am EST

Focus: FUNDS

John Bonnanzio

Editor, Fidelity Monitor & Insight

Here’s the non-technical reason why we downgraded Fidelity's Inflation-Protected Bond (FINPX) and its related Index funds to "OK to Sell" —  with CPI mostly running under 2% for years, and with no sign that inflation is poised to accelerate, “paying” for inflation protection does not make sense, asserts John Bonnanzio, editor of Fidelity Monitor & Insight.

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Of course, today’s low-rate, low inflation environment may not last forever. But for now, many factors are exerting downward pressure on inflation, thereby keeping low-yielding bonds relatively attractive.

These conditions include tepid economic growth, cheap domestic energy, a large contingent labor force, low capacity utilization, and technology-driven efficiencies that reach from the factory floor through distribution channels to the end user. (Think Amazon.)

So, with the notable exceptions of health care and college (where the government is working on your behalf to help rein-in costs!) everything from the price of a dozen eggs to your smartphone plan is more affordable.

None of the above has been lost on investors, including bond-buyers, gold/silver bugs, and those seeking 30-year mortgages. With yields, prices and interest rates all in retreat, the market is signaling that it sees low inflation and slow economic growth ahead.

As for the Treasury Inflation-Protected Securities (TIPS) that are the backbone of Fidelity’s aforementioned fund, they operate a bit differently than regular bonds: Twice a year, the Treasury adjusts a TIPS’ principal (par value) to reflect inflation, or deflation. So, whenever investors have diminished expectations for inflation, their value declines.

Despite their management fees, you’re probably better off holding TIPS in a fund rather than individually. That’s because the semiannual coupon adjustment from TIPS can create federally taxable “phantom” income.

A good way to evaluate TIPS versus conventional Treasuries is the breakeven inflation rate. If inflation runs higher than that, TIPS are the better deal and vice versa.

That rate is simply the difference between a TIPS yield and the yield on the same maturity Treasury. Right now, the breakeven rate for 10-Year TIPS is 1.83%, versus an actual inflation rate of just 1.6% over the past year.

While you can buy TIPS directly (they come in 5-, 10-, and 30-year denominations) or through funds, we don’t see any compelling reasons to own them right now. We prefer that income-oriented investors use a diversified mix of corporate and government bonds (of varying maturities).

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