Time for TIPS Horizon Funds:
An Editorial

A subpage of The U.S. Real Term Structure
by J. Huston McCulloch
Department of Economics, Ohio State University

Rev. 9/13/05

There are now 17 primary TIPS outstanding, with maturities ranging from 2007 to 2032. Half a dozen mutual funds specializing in these bonds provide small investors with greater liquidity and convenience than direct holdings.

However, all the existing funds offer investors just a single vanilla maturity choice, which usually boils down to holding all the bonds in rough proportion to their outstanding volume. In fact, investors can have very different maturity needs. They don't need a full 31 flavors, but should at least be offered a choice of Chocolate, Strawberry or Pistachio. It is time for specialized funds to emerge, that cater to the three approximate investment horizons 2010, 2020, and 2030.

TIPS are essentially riskless investments, so long as their maturity corresponds to the investor's dissaving plans. However, if they have the wrong maturity, they still may expose the individual investor to either present-value risk or roll-over risk.

Present-Value Risk: Younger investors who are saving for a child's college in the vicinity of 2010, or older ones who have already retired and don't expect to live to 2030, can experience significant capital losses to the extent that their savings are invested in the 30-year TIPS and real rates rise. A fund that held only the shorter term TIPS would protect them from these potential capital losses, while assuring them a relatively predictable real return to their short-term investment horizon.

Roll-Over Risk: On the other hand, young investors who are saving for retirement in 2030 or later and want to get a safe, inflation proof return on that portion of their savings that they don't want to gamble on stocks still may run the risk of an uncertain real return if their funds are invested in the shorter-term TIPS and future real rates turn out to be lower than today's forward real rates. A fund that held only the longer term TIPS would approximately lock in today's long-term real rates, again assuring savers a relatively predictable real return to their respective long-term investment horizon. There is no point in locking in today's low and recently even negative short-term real rates unless one really has a short-term investment horizon.

I therefore propose that the time has come for mutual funds catering to investors interested in these three approximate investment horizons. These could in fact be called the [Fund Group Name] Horizon 2010 Fund, [Fund Group Name] Horizon 2020 Fund, and [Fund Group Name] Horizon 2030 Fund. The word "Horizon" is already used by a number of funds offered by different groups, and therefore is not proprietary.

The Prospectus for a Horizon X fund would, for example, require it to hold a portfolio of TIPS, or investment grade private indexed bonds as available, whose final maturities are all within 5 years of date X. (Earlier I proposed basing eligibility on Macaulay duration, but final maturity would be easier to explain, and the fund can simply report the portfolio's average Macaulay duration for the benefit of more sophisticated investors.)

At present there are only three indexed bonds maturing within 5 years of 2020, the 1/15i, the 7/15i, and the 1/25i, but mixing these would give an average final maturity as close to 2020 as desired.

Greater precision than 10-year increments is not important for the average small investor. However, if a small investor did want to target other horizons such as 2015 or 2025, or to fund projected expenditures in more than one future decade, he or she could easily approximately hedge these plans simply by mixing two of the three Horizon funds in the appropriate proportions, according to their actual average durations.

If investors have a change in their plans for the future, the great liquidity and convenience of modern mutual fund groups would permit easy realignment of their TIPS portfolios. And if they have no definite plans for their savings, they would have nothing to lose by being in the wrong maturity, or even in a generic, unspecified-horizon TIPS fund.

American Century already offers a series of "Target" funds holding only nominal STRIPS with a specific maturity date range in 5-year increments such as 2010, 2015, etc. However, because these are not inflation-indexed, they, like non-indexed whole bond funds, serve no long-run investment purpose.

Although indexed STRIPS exist in small quantities, the precision of the American Century Target Funds is not required by the average small investor. Investing in whole bonds would give Horizon Funds the advantage of the greater liquidity and smaller transactions costs of the whole bond market. Whole bonds would expose long-term investors to a little coupon-reinvestment risk, but this would be approximately immunized to the average Macaulay duration date of the fund.

Horizon funds catering to American savers should primarily hold US CPI-linked bonds in order to minimize real exchange rate risk, but could perhaps be permitted to hold foreign inflation-linked bonds up to say 10% in any one currency and 30% in all foreign currencies together, in order to take advantage of potentially higher real yields abroad.

Let's go for it!