September 22nd at 1:00am by Tom Lydon

We recently got on the phone with Chris Caltagirone, vice president and product manager at PIMCO. to discuss anything and everything related to TIPS, including their role in your portfolio and exchange traded funds (ETFs).

What are TIPS?

TIPS are Treasury Inflation-Protected Securities. TIPS are similar to regular Treasury bonds in that they have the same credit risk effectively none and theyre issued by the government. But the difference is how they pay the coupon. If you buy $100 at inception and the rate of inflation is currently 2% for 10 years (the date of maturity), the principal will grow 2% each year, Caltagirone says.

When were they created?

They were created in the United States in 1997. It was something the Treasury had thought about doing for awhile, Caltagirone says. Were far from the first country to offer them the United Kingdom has had them since the 1980s. But the U.S. market for TIPS is now the largest in the world.

Why were they created?

The main reason TIPS were created was to give the public a debt instrument that is directly linked  to the rate of inflation. No other investment where it moves up and down with whatever inflation is measured at, Caltagirone says.

The Treasury issued them for two reasons:

• There was demand for them
• Theyre incentive for the Treasury to keep inflation in check. If inflation runs rampant, the Treasury knows it will have to pay more and more to TIPS holders. It forces them to take inflation seriously, says Caltagirone. Theyre a check and balance for the Federal Reserve and the Treasury.

Whats the TIPS market right now?

Its around $550 billion. Total U.S. debt is around $12 trillion, making TIPS about 5% of the total U.S. debt. The market for TIPS has grown, Caltagirone notes, and it could grow even more.

TIPS, being relatively new instruments, have not yet been tested in a period of stagflation. Will they hold up if this happens?

In theory, Caltagirone says, TIPS would hold up in a period of stagflation that is, high inflation, low growth. In the late 70s, anything over five years of maturity suffered and the yields went up sharply. Inflation is the #1 enemy of regular bond that dont have inflation protection.

Because TIPS strip out the price risk, the theory is that theyd hold their value better.

What are the risks of TIPS?

In short, the risk is that you could buy some TIPS and inflation doesnt pan out like you expected it might. If inflation doesnt pan out, Caltagirone says, then youre stuck with the lower yield.

If a period of deflation is entered, then it cuts into your yield. The worst-case scenario is deflation; the best-case is stagflation.

What strategies can I use when it comes to TIPS?

Caltagirone says that most investors should think of TIPS as a strategic position not one necessarily of buy-and-hold, but held for a period of time, such as one, two or three years. Tactically trading TIPS could shortchange investors of their rewards: The benefits of them get felt out over longer periods of time.

Thats because, Caltagirone says, inflation is very noisy in the short-term since its measured month-to-month. Once thats all smoothed out, you can see where the overall trajectory is headed.

Where do TIPS fit in with other inflation hedges?

One benefit of TIPS, Caltagirone notes, is that theyre directly linked to inflation by contract. Commodities can be a useful hedge against inflation, but theyre not contractually obligated to deliver on that, so theres no guarantee. [Commodities] tend to drive inflation in the short-term, but over the long-term theyre not all that correlated with inflation.

What TIPS ETFs are available?

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.