Sell TIPS to hedge against higher interest rates?

Is now the time to buy more TIPS in my 401(k) or to sell TIPS as a hedge against rising interest rates next year? I’m 57 years old and wonder if I should buy a short-term investment grade bond fund before interest rates go up. Or is it better to buy them when interest rates are much higher?

I cannot recommend what you should do because I have very little information about your situation, other than your age. But I can give you some pointers that might help you think about these questions.

You are asking questions involving market timing and also about your overall asset allocation. To get answers that make sense, you need to think clearly and logically about this. Bonds and bond funds are not quite as simple as you might think.

As Paul Merriman has written before, there are three rational reasons to own TIPS and other fixed-income funds. First, you might want to buy low and sell high in order to make a profit. Second, you might want these funds so you can collect the income they provide. Third, you might want them in order to dampen the volatility of the equities in your portfolio.

If your goal is to collect income, then it makes sense to hold these funds as long as they provide the income you need. There is no need to worry about their current price because they are not for sale.

If your goal is to reduce the risk of your overall portfolio, then your concern should be having the right amount of fixed-income to keep your risk under control. At age 57, your fixed-income investments should probably make up somewhere between 20 and 50 percent of your total portfolio. If your current holdings are far from the right level, I suggest you avoid making a big change all at once. For example, if you have only 10 percent in fixed-income and you determine you should have 40 percent, the difference is 30 percent of your portfolio. That’s a very big change, and I would consider making it gradually over a year or two.

Finally if your goal is to buy low and sell high, then knowing the future of interest rates could be very helpful. Usually, bonds lose value when interest rates rise and gain value when rates fall. There are (at least) two major problems here. First, it’s impossible to know what rates will do. We can be pretty sure they’ll go up, but we don’t know when, how far or for how long. The same is true in the other direction.

If you think you can profit by predicting interest rates, I hope you realize you will be competing against an army of full time professionals with massive amounts of computer power and the ability to trade instantly. Another problem with your question is that TIPS funds are not directly correlated to changes in interest rates. They are a hedge against inflation, but not necessarily against rising interest rates. Neither will short-term bond funds give you much reward for correctly predicting changes in interest rates. If you really want to make that bet (and we don’t recommend it!), you should use intermediate-term and long-term bonds, as they are much more sensitive to changes in interest rates.