Here’s a look at what individual investors should know about Treasury inflation-protected securities

Fears of rising prices have ignited interest in Treasury inflation-protected securities as a way to hedge against inflation.

A popular approach to investing in TIPS has been through mutual funds and exchange-traded funds. This year through...

Here’s a look at what individual investors should know about Treasury inflation-protected securities

The Treasury Department has issued TIPS since 1997. They are backed by the government but also have risks.

Photo: Stefani Reynolds/Bloomberg News

Fears of rising prices have ignited interest in Treasury inflation-protected securities as a way to hedge against inflation.

A popular approach to investing in TIPS has been through mutual funds and exchange-traded funds. This year through Aug. 31, about $47 billion poured into ETFs and open-ended bond funds with inflation protection as their themes, Morningstar Inc. reports. That is up from $8.3 billion in net inflows during the same period in 2020. That has pushed total net assets in this class of funds and ETFs to more than $266 billion.

The largest fund in this sector is Vanguard Short-Term Inflation-Protected Securities ETF (VTIP). It has had net inflows of nearly $12 billion since Jan. 1, boosting its assets under management to about $54 billion.

U.S. economic data are flashing warning signs on what lies ahead. Federal Reserve Board Chairman Jerome Powell as well as many economists and investment strategists say they expect inflation to persist through 2022 due to a confluence of factors. These include: supply-chain and labor shortages; the rise in energy, food and housing prices; and a boom in consumer demand. In August, the consumer-price index, or CPI—a measure of personal consumption—was up 5.3% over the same period last year. That marked the highest level of inflation in 13 years.

“The inflows into the TIPS sector are coming from individual investors, financial advisers on behalf of clients, institutional investors, central banks and global pension schemes,” says Gemma Wright-Casparius, a principal and senior portfolio manager of fixed income at Vanguard. 

The intricacies

Because of their built-in protections against inflation, TIPS are recommended by some experts as fixtures in fixed-income portfolios. Todd Rosenbluth, head of ETF and mutual-fund research at CFRA, suggests they can even be a replacement for traditional Treasurys. The value of each bond’s principal is indexed to the CPI, and so increases at the same rate as inflation, though the interest rate payable stays the same. 

Here is an example of how TIPS work.  If you bought a security with a face value of $1,000 and the CPI rose 1% over the next six months, the value of the bond principal would rise $10. And because the interest payments are based on the principal, interest payments would also rise. At maturation, in addition to interest payments already received, the holder receives either the face value of the bond or the adjusted value of the principal, whichever is greater. TIPS come in five-, 10- and 30-year maturities. Like traditional Treasurys, they are backed by the U.S. government and make semiannual interest payments.

But TIPS do come with risks. Ellis Phifer, managing director of fixed-income research for Raymond James, says TIPS typically underperform Treasurys, “especially in times of deflation.” Though deflation is rare, if it does happen, as prices fall, the value of the principal also will fall as it moves in line with the index. So, investors risk lower interest payments, and principal loss if they have to sell before maturity; principal loss at maturity is also a risk for investors who bought the security at a premium.

Another risk TIPS holders face is, during periods of inflation, interest rates on traditional Treasurys and other bonds can offer higher yields than what TIPS and their fixed coupons offer. With the buying and selling of traditional Treasurys, says Brian Therien, senior fixed-income analyst at Edward Jones, “Inflation expectations are built into their prices.”

When evaluating whether to buy TIPS or traditional U.S. Treasurys, Mr. Therien suggests investors look at a key benchmark: the break-even inflation rate published by the St. Louis Federal Reserve Bank. This rate reflects a market-based measure of expected inflation. For example, the break-even inflation rate for 10-year Treasurys on Sept. 27 was 2.40%. If an investor feels inflation will be higher than 2.40% over the next 10 years, then the 10-year TIPS would be considered a better buy than the standard 10-year U.S. Treasury.

“Also keep in mind that you must pay income taxes on any increases to par value on these investments until your TIPS mature,” Mr. Therien says. “You can manage this by keeping them in tax-advantaged retirement accounts.”

Fund dynamics 

Funds and ETFs that hold TIPS tend to focus on different durations. Some, such as Schwab U.S. TIPS ETF (SCHP), are passive funds with short-term horizons geared to investors betting that inflation will climb. The $20 billion fund tracks the Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index (Series L), and its TIPS all have at least one year remaining to maturity and are rated investment grade. Its 12-month yield ended Aug. 31, 2021, is 3.01%. For investors with a long-term view on inflation, there are funds such as the $835 million Pimco 15+ Year U.S. TIPS ETF (LTPZ), which tracks an index of TIPS with maturities of at least 15 years. Its 12-month yield ended Aug. 31, 2021, is 3.08%.

Investors should look at each fund’s expense ratio to determine the returns after management fees. Also, Ms. Wright-Casparius says, look at the contents of the fund’s portfolio so you can assess the investment risk. In addition to inflation-protected securities, she says, “Some funds hold mortgage-backed securities, global inflation-linked bonds, commodities and wide mandates that vary over time.”

Morningstar data indicates the top three inflation-protected bond funds offered to individual investors in terms of year-to-date total returns through Aug. 31, 2021. All have more than 50% of their portfolio invested in TIPS. They are:

Eaton Vance Short Duration Inflation-Protected Income Fund (EARRX) This $360 million open-end fund invests at least 80% of its assets in TIPS with a maturity up to 3.5 years. YTD return: 5.82%. Expense ratio: 0.90%. 12-month dividend yield: 2.75%.

Wells Fargo Real Return Fund (IPBJX) The $60 million open-end fund invests 80% in debt securities, 65% of which are TIPS, 20% in equities. YTD return: 5.46%. Expense ratio: 0.40%. 12-month dividend yield: 3.68%.

American Century Short Duration Inflation (APOGX) At least 80% of the open-end fund’s $2.8 billion in assets are invested in TIPS. It may invest 20% of its assets in securities dominated in foreign currencies. YTD return: 5.35%. Expense ratio: 0.01%. 12-month dividend yield: 1.37%.

These are the top three inflation-protected ETFs that have had the highest returns YTD through Sept. 24, according to an analysis by CFRA.FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT) This $1.4 billion fund invests 80% in securities that are in the iBoxx 3-year Target Duration TIPS Index. YTD return: 4.17%. Expense ratio: 0.18%. 12-month dividend yield: 3.21%.iShares 0-5 Year TIPS Bond ETF (STIP) The $6.7 billion fund invests in TIPS that have a maturity of less than five years. It generally invests 90% of its assets in the Bloomberg Barclays U.S. Treasury TIPS 0-5 Index. YTD return: 4.15%. Expense ratio: 0.05%. 12-month dividend yield: 3.19%.Pimco 1-5 Year U.S. TIPS Index ETF (STPZ) The $1.1 billion fund seeks to provide a total return of the ICE BoA 1-5 year US Inflation-Linked Treasury Index that tracks TIPS with maturities ranging from one to five years. YTD return: 4.14%. Expense ratio: 0.20%. 12-month dividend yield: 2.9%.

Ms. Ioannou is a writer in New York. She can be reached at reports@wsj.com.