How investing in TIPS bonds can protect investors against rising inflation
January 20 2022 - Team Stockal
The U.S. inflation levels have peaked to their highest levels lately which shows that the Consumer Price Index (CPI) increased to 7% in December 2021 (chart below). The biggest driver of inflation according to most economists is the mismatch between supply and demand. Shoppers are feeling the pinch all around – from grocery stores to furniture and even gas stations. These higher inflation numbers are not just the problem in the U.S. but also in many other European nations too, with Germany reporting its highest inflation of 5% in December.
What can investors do in this higher inflation environment?
Inflation continues to be the biggest concern and several investors are looking for investment options that keep pace with or hopefully beat the rate of inflation. This has led to an environment where Treasury Inflation-Protected Securities or TIPS have become a popular investment option for investors looking for protection from rising inflation.
Exhibit 1: Components of higher inflation numbers over the year
Source: Bureau of Labour Statistics, Jan 2022
Higher inflation is not favourable to traditional bond holders. Let’s find out why.
When an investor considers a traditional bond, which pays 3% and the inflation is about 2%, for example – the purchasing power grows, as the returns from these bonds are greater than inflation. However, if the inflation is higher than the bond interest during the life of the bond, then such a bond instrument has not kept up with inflation and the purchasing power of an investor falls. In 2021 we also saw how bond investors didn’t gain any returns – technically due to higher inflation. Thus the real yields on U.S. 10-year Treasuries remained negative. This is where Treasury Inflation-Protected Securities, or TIPS, comes into place.
What is Treasury Inflation-Protected Securities or TIPS?
Treasury Inflation-Protected Securities or TIPS are U.S. Treasury bonds which safeguard investors from a deterioration in the value of their money. TIPS are similar to treasury securities which are issued by the U.S. government and maintain full credit worthiness as it is issued by the federal government. As the inflation goes higher, TIPS alter in price to adjust for the rising inflation thereby sustaining its real value.
How does it work?
TIPS are Treasury securities whose principal value is indexed to the rate of inflation. When the inflation rises, the TIPS’ principal value is adjusted upward and in a deflationary environment, the principal value is adjusted lower. Although there are several measures of inflation, TIPS are referenced to the Consumer Price Index or the CPI data.
Understanding TIPS through Real yields and Nominal yields
Real yields are after adjusting for inflation, and nominal yields does not consider inflation numbers. TIPS can be a complicated investment to understand, but investors should realize that if a 10-year TIPS has a negative yield, it does not mean investors will earn less than zero on this investment. Taking a hypothetical example, the real return of -1.7% means that the asset will lag official U.S. inflation by 1.7% a year over its term. Inflation currently is at 7% which translates into a nominal return of 5.3% for a TIPS investment which is much higher than a nominal U.S. 10-year Treasury yield of 1.7% currently. A point to consider is that if inflation falls to 4%, then the investment on the TIPS would yield 2.3% (4%-1.7%) which is still higher than the 10-year benchmark treasury yields of 1.7% currently.
Does investing in TIPS help beat the inflation?
With the current real yields being negative, it is possible for returns to beat inflation over the short run. Whether an investor holds individual TIPS or invests through a mutual fund or an exchange-traded fund (ETF), the total returns over the short investing horizons can beat inflation. Although past performance is not a guarantee of future returns, the one-year total returns on the Bloomberg U.S. TIPS Index was around 6.8% in December 2021.
TIPS coupon payments fluctuate with the inflation levels
TIPS have a fixed coupon rate, which are normally based on the principal value of the security. If inflation rises, that rate is based off a higher principal amount and the coupon payments will also change accordingly. The table below provides a hypothetical look at the TIPS principal value and coupon payment based on a constant rise in inflation by 3%.
Exhibit 2: TIPS principal values and coupon payments adjusted for inflation
Source: Charles Schwab Report, December 2021
TIPS vs. Traditional Treasury Bonds
To understand the difference between TIPS and traditional treasuries, investors need to understand the breakeven rates. A breakeven rate is the difference between the yields of a TIPS and the yield of a traditional treasury security of the same/comparable maturity period. This difference is what inflation would need to average over the life of the TIPS for it to outperform the traditional treasury.
Let us understand this with an illustration: if a five-year TIPS offers a yield of roughly negative 1.6% returns today as compared to a 1.2% yield offered by the traditional five-year treasury, then the difference between the two yields in 2.8% (note that the TIPS yields in negative since it is adjusted to inflation). If the CPI is more than this 2.8% each year for the next five years, then the TIPS would provide a higher total return than the traditional treasury investment. However, if inflation averages to less than 2.8% which is not the case currently, then the traditional treasury would outperform the TIPS bonds.
While evaluating TIPS, investors need to consider the breakeven rate just in a similar way as we consider inflation. Breakeven rates have fallen from their recent highs, however, they are still elevated compared to the historical numbers (chart below). The average five-year breakeven rate since inception in 1.85%.
Exhibit 3: Five-year breakeven rates vs. Average
Source: Charles Schwab Report, December 2021
Investing in TIPS ETFs
After having a fair understanding of how the individual TIPS bonds work from the above illustration, it is convenient for investors to look at investing in these asset classes through the TIPS ETFs. Investing in these bonds through ETFs is one of the best ways to have better diversification rather than buying individual TIPS and usually at a lower cost depending on the ETF or the fund. TIPS ETFs usually invest in a basket of bonds thus providing an easy way to invest in the asset class with different maturity dates and can be traded on the exchange like any other stock ETF. Normally, TIPS outperform traditional U.S. government bonds in a higher inflationary environment and usually underperform the traditional government bonds when inflation is lower than the market expectations.
TIPS bonds which investors can look at on our platform
We do have some of the best known TIPS ETFs available on our platform for investors looking to invest in Bond ETFs along with protection from the current higher inflation. The broad spectrum of TIPS funds include:
- iShares TIPS Bond ETFs (Ticker: TIP)
- Schwab U.S. TIPS ETF (Ticker: SCHP)
- PIMCO Broad U.S. TIPS Index ETF (Ticker: TIPZ)
- SPDR Bloomberg Barclays 1-10 Year TIPS ETF (Ticker: TIPX) which is a medium-term maturity date ETF
Some of the shorter maturity date TIPS ETFs include:
- Vanguard Short-term TIPS ETF (Ticker: VTIP)
- iShares 0-5 Year TIPS Bond ETF (Ticker: STIP)
Investors looking at bond investments like the U.S. Treasuries should consider allocating 10-20% of their investments in TIPS to help protect against unexpected surge in inflation numbers. However, investors should understand that TIPS Bonds are also subject to the inverse relationship between their prices and yields like the traditional treasuries and they are likely to underperform traditional treasuries if inflation goes down further to normal levels. In a higher inflationary environment like what we are seeing today, it’s worth considering TIPS ETFs for short-term investment (3-6 months time horizon) as these are one of the most straightforward ways to protect investors’ portfolios against rising inflation. Investors should also remember that TIPS are inflation hedges to protect portfolios in a volatile equity environment and are clearly not substitutes for equity investments.