Don't get bit by your TIPS!

Many mom and pop investors buy Treasury inflation-protected securities (TIPS) in the belief that they are as safe as safe can be: The full faith and credit of the U.S. government stands behind them, and their returns adjust to keep up with inflation.

But here's a fact that some may find surprising. If interest rates move up faster than consumer prices do, their TIPS investments can turn around and bite them. A low-yielding inflation-protected bond could actually lose value faster than a comparable non-inflation protected bond in that scenario.

Because the stated yield of TIPS is lower than that of regular Treasuries (an inflation adjustment is supposed to make up the difference), they would react more extremely to an increase in rates. 

Furthermore, there is reason to believe that scenario could play out exactly that way. Interest rates have been low for a few different reasons: Inflation is low. The Federal Reserve has been buying bonds on purpose to keep rates low as part of its economy-goosing quantitative easing policy. Investors have been bidding up Treasuries (thus dampening yields) as a flight to safety whenever they worry that the economy is weak or unstable.

But some day the Fed will exit its bond-buying program. And investors, already less afraid than they have been, started demanding more return on their Treasuries earlier this year.

Near the end of January, yields on 10-year Treasuries climbed from 1.84 percent to 2 percent, before sliding back to 1.88 percent where they are now. And a 2-percentage point increase in interest rates could shave 14.9 percent off the value of a 10-year bond, according to the American Association of Individual Investors.

Ten-year TIPS, meanwhile, have been bid up so much their real yield is a negative 0.63 percent, according to Treasury Department auction data from the end of January. TIPS investors are basically betting that inflation will be above 2.5 percent over 10 years.

Of course, that could well happen.  A fast pickup in oil prices could push the CPI up in a hurry.

However, if not, it pays to spend a few minutes reviewing the fixed income portion of your portfolio architecture.   Be sure it continues to provide the diversification and downside protection, in addition to income, that it is meant to, and not a source of unnecessary risk.

My team and I are always here to help!  Consultations are free! Ubs.com/team/dmg.