Strategies for investing in TIPS are primarily two-fold: (1) how much in fixed income should be invested in TIPS versus in nominal bonds; and (2) whether one should invest in individual TIPS or in a TIPS mutual fund or ETF.
Experts differ in what percentage of fixed income an investor should invest in TIPS.
TIPS Should Dominate
Proponents of TIPS argue that TIPS should dominate an investor’s fixed income portfolio because the biggest risk in fixed income is inflation and TIPS are guaranteed a real rate of return regardless of actual inflation.
Boston University Finance Professor Zvi Bodie says TIPS are the safest long-term investment. He sees no point in taking inflation risk with regular bonds.
Research has also shown that TIPS are a better diversifier to stocks than nominal bonds in a portfolio. TIPS reduces the risk of the overall portfolio more than nominal bonds.
Some other experts suggest splitting fixed income investments 50:50 between nominal bonds and TIPS. Nominal bonds protect against expected inflation and deflation while TIPS protect against unexpected inflation. Nominal bonds have a higher expected return due to the inflation risk premium. Nominal bonds also do better in financial crisis due to “flight to safety.”
David Swensen, Chief Investment Officer of Yale Endowment, recommended in his book Unconventional Success splitting fixed income investment 50:50 between short-term Treasury bonds and TIPS.
Larry Swedroe, investment advisor and author of The Only Guide to a Winning Bond Strategy You’ll Ever Need, suggests that an investor should shift the fixed income investment between TIPS and nominal bonds and shift the average maturity of TIPS investments based on the real yield and the breakeven inflation rate in the market.
Mr. Swedroe suggests investing more in TIPS and lengthening the maturity when real yields are high, and/or when breakeven inflation rates are low.
I believe as a general rule TIPS should dominate the fixed income investment. I’m willing to invest more in longer term TIPS when real yields are high, when breakeven inflation rates are low, and/or when real yield curve is steep.
Mutual Fund or ETF
For retail investors, a TIPS mutual fund or ETF offers a convenient and cost-effective way to invest in TIPS. You get instant diversification, expert management, excellent liquidity, and easy tax reporting.
For ultimate control over maturity and the lowest cost of ownership over the long term, investing in individual TIPS can be better than investing in a TIPS mutual fund or ETF.
Individual TIPS are also an excellent choice for retirees during the distribution phase. A ladder of individual TIPS naturally winds down itself.
I invest in both individual TIPS and a TIPS mutual fund. A TIPS mutual fund is an ideal place for reinvesting interest payments from individual TIPS and for accumulating investment until the next auction for the desirable TIPS maturity comes along or when the market conditions on the secondary market becomes favorable.