Most Popular ArticlesMay 19, 2009
Duration
Duration is a dimensionless number, and measures the sensitivity of a bond’s price to changes in interest rates. The price of a bond with a duration of 10 will change twice as much as that of a bond with a duration of 5 for a given change in interest rates. The financial press often confuses duration with maturity. Duration and maturity happen to be equal for zero coupon bonds, but that is where the similarity ends.The chart below shows the real interest rates for the same 30-year TIPS and the nominal interest rates for the corresponding 30-year Treasury bond:
The correlation is very high for most of the period, with the exception of 2008, when real interest rates climbed. Although there was inflation at the time, the fall in real interest rates caused the value of TIPS to decline.
In an inflationary environment, two conflicting forces drive real interest rates. Bond investors, faced with rising nominal interest rates, demand higher risk premia, causing real interest rates to rise. These investors will also find TIPS a more attractive asset class, and supply and demand imbalances will push down real interest rates. With the relatively nascent TIPS market, during which time inflation has been well-contained, one cannot forecast which of these forces will be more dominant if inflation escalates.
Bonds versus ETFs
Investors can choose from two TIPS ETFs – Barclays’ iShares TIP and State Street’s IPE. The two ETFs are similar, with nearly identical performance records, expense ratios, and average maturities. TIP was the original entrant in the market, and has nearly $12 billion under management, versus approximately $225 million for IPE.
These ETFs differ from individual bonds in three important respects. The ETFs charge an expense ratio of approximately 0.20 which, while relatively modest, will eat up more than 10% of the fund’s return in today’s no-inflation environment with real interest rates under 2.00% for 10-year bonds. Individual bonds can be purchased directly from the Treasury with no transaction costs. Second, the ETFs are managed to a constant maturity of just over nine years, whereas individual bonds have fixed maturities.
The crucial difference is that TIPS ETFs increase their monthly distributions above the level of their monthly coupons, to equal the amount by which their principal value accrues. This eliminates the phantom tax issue, making them preferable for taxable investors.
Display article as PDF for printing.
Would you like to send this article to a friend?
Remember, if you have a question or comment, send it to .
