How TIPs Inflate Their Yields

You think that some of the yields to be had when buying TIPs these days are simply mouthwatering and hard to resist given the current zero interest rate environment.

Before you jump in with both feet, consider this WSJ report (subscription required) titled “How Inflation-Protected Funds Get To Inflate Their Yields:”

How would you like to triple the yield on your bonds?

Most of us can only dream. But look at the eye-popping variation in yields among funds that focus on Treasury inflation-protected securities, or TIPS, the U.S. obligations that rise in value as the consumer-price index goes up.

Among the 173 TIPS mutual funds tracked by Morningstar, the reported “SEC yields” as of March 31 ranged from minus-0.77% to 5.58%, with 12 funds yielding at least 5%. Four of the seven exchange-traded funds that specialize in TIPS displayed yields greater than 5%, with Pimco 15+ Year U.S. TIPS Index leading the pack at 6.07%.

Yet no TIPS yield more than 1.75%. How could anyone but an alchemist generate 5% or more out of 1.75% or less?

The answer lies hidden in the term “SEC yield.” In 1988, the Securities and Exchange Commission forced funds to include only dividends and interest income in the yield that they must show investors.

The return on TIPS, however, comes not just from interest income but also from any adjustment in value as inflation rises.

The SEC hasn’t issued any guidance to fund companies on how to handle this peculiarity when they show standardized yields, says Gene Gohlke, associate director for examinations at the agency. As a result, firms are free to do more or less as they please, without running afoul of the rules.

Given the way many TIPS funds interpret the SEC yield formula, the change in inflation over the latest reported month gets added to interest income to produce an annualized figure. Thus, in months that capture a small inflation change, SEC yields on TIPS funds will be low. In months like April, when the rise in the Treasury’s inflation value was about 0.5%, SEC yields can brush 6%.

The inflation change upon which TIPS funds will be basing their SEC yields in May will be nearly 1%, notes Dan Dektar, chief investment officer at Smith Breeden Associates in Durham, N.C. That suggests some funds might soon sport much higher yields.

A few brave TIPS funds back the inflation adjustment out of the SEC yield, producing a much smaller number often called “real yield.”

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The bottom line: While the SEC yield is a decent guide in other bond funds, it can steer you wrong in an inflation-protected bond fund. Before buying a TIPS fund, ask instead what its real yield is.

The real yield is what matters if you are counting on generating spendable income, and not the adjustment for inflation. This “adjustment” does not make TIPs a bad investment, but you need to be aware of how the yield is calculated so can compare apples with apples when looking at different Funds/ETFs.

Disclosure: No holdings