The low returns offered by TIPS and their sensitivity to interest rates do not make a compelling investment even after recent weakness. We believe corporate bonds. with their relatively higher yields and still good underlying fundamentals provide a better option for investors. Alternatively, underperformance of municipal bonds provides another high-quality option. After-tax yields of top-rated municipal bonds offer a compelling total return, even if TIPS receive a greater-than-expected boost from inflation. For investors fearful that inflation will eat away at bond returns, TIPS can provide protection, but like conventional Treasuries still possess very expensive valuations that recent modest weakness has not erased.

A slowing pace of inflation, economic growth concerns, further declines in commodity prices, most notably energy prices such as oil and gasoline, have weighed on TIPS’ prices recently. Year-to-date through April 24, 2013 TIPS are lagging among bond domestic bond sectors, trailing conventional Treasuries and the broad bond market as measured by the Barclays Aggregate Bond Index .

After a difficult few weeks, the breakeven inflation rate implied by 10-year TIPS dropped to 2.4% as of April 25, 2013, its lowest level since late August/early September 2012, and has dropped by 0.2% since mid-March. This provides an opportunity for investors who believe inflation will actually be higher than what is currently being priced in by the TIPS market. However, the 2.4% implied breakeven rate of 10-year TIPS is still at the high end of a 1.50% to 2.65% range since mid-2009. In that context, TIPS weakness is very modest.

Although TIPS can provide protection from inflation, they are not without risks, interest rate risk being the primary risk. Trailing TIPS’ returns look appealing, but much of that can be attributed to the long-term decline in interest rates that has fueled the broad bond full market. The TIPS market, as a whole, is more interest-rate sensitive than the broader bond market, therefore benefiting more from the steady decline in yields over the years. The average duration of the Barclays TIPS Index, a common benchmark for many TIPS funds and ETFs, is 6.1 years, longer than the 5.3-year duration of the Barclays Aggregate Bond Index.

The interest rate sensitivity is an important component of TIPS and a characteristic they share with conventional Treasuries. While TIPS can protect against inflation, the added inflation compensation can be easily offset by price declines associated with higher interest rates. If interest rates rise in response to economic growth, or a Fed interest rate hike, while inflation expectations remain modest, price declines may pass through to TIPS holders with little offset. With interest rates still near record lows, interest rate risk presents a greater long-term risk, especially if inflation fails to accelerate as anticipated. Furthermore, CPI inflation is currently running at a 1.5% annualized rate, below the 2.4% breakeven rate implied by TIPS. In short, with implied inflation higher than actual inflation, the bond market has already priced in a modest rise in inflation.

About Anthony Valeri

As Senior Vice President and Market Strategist, Anthony is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy. Anthony regularly communicates market strategy to LPL Financial advisors, contributes to the Research department’s flagship publications, is a speaker at LPL Financial conferences, and authors Bond Market Perspectives, a weekly client commentary on the bond market. Anthony has been quoted in a number of national online and print publications including Bloomberg News, Reuters, and Dow Jones. Prior to joining the Research Department in January 2002, Anthony was Head Trader of the LPL Financial fixed income-trading desk. Anthony has 18 years of investment experience.

Anthony received a BA in Quantitative Economics and Decision Sciences from the University of California at San Diego in 1992 and received his Chartered Financial Analyst designation in September of 1999. Additionally, Anthony is Series 7 and 63 registered. Anthony is a member of both the Association for Investment Management and Research and the Financial Analysts Society of San Diego. Anthony has been with LPL Financial since June 1993.