TIPS, which are government notes and bonds indexed to the CPI, are a relatively new form of inflation hedge. Since their introduction, the market has slowly grown in size and liquidity. Their structure is simplicity itself, and ensures that if the CPI is an accurate measure of inflation, the holders of these bonds will be protected against diminution of the real value of their assets by the full faith and credit of the U.S. Government. Any allocation to TIPS in the long run needs to be considered outside the normal fixed income slice of the pie. If unexpected inflation surges, traditional bonds get clobbered while TIPS prosper.
Deflation favors nominal bonds.
The TIPS allocation should be considered in the demand for inflation protection and should be aggregated with real estate and any commodity exposure. Having said that TIPS aren't like traditional bonds and that they should be allocated a separate slice of the allocation pie, it may appear surprising that Commonfunds' High Quality and Multi-Strategy Bond funds have had an allocation to TIPS for some time now. This is not because they are substitutes for traditional bonds, but because our managers believe they have been priced so attractively given their risk profile that TIPS will add value. In the first quarter this was certainly the case. If one day the real yield on these instruments falls dramatically, one can expect they will no longer have an opportunistic role in these bond portfolios.