A version of this article was published in the December 2021 issue of Morningstar FundInvestor. Download a free copy of FundInvestor by visiting the website.
With consumer prices rising at the fastest rate in more than 30 years, investors concerned about inflation may be interested in understanding what options are available to protect against a loss of purchasing power. Treasury Inflation-Protected Securities are a pure inflation hedge, and funds that invest primarily in TIPS can offer investors diversified exposure to the TIPS market. Like US Treasuries, TIPS carry minimal credit risk, but unlike Treasuries, TIPS have a built-in feature that adjusts their principal value to keep pace with inflation (according to as measured by the consumer price index). This may sound straightforward, but there are some important features of TIPS that investors should consider before investing.
While they may appear risk-free, TIPS are certainly not immune to short-term price swings, whether driven by investor sentiment or movements in interest rates. In fact, US TIPS are exceptionally sensitive to changes in interest rates, as TIPS issuance has been bundled into longer maturities. Changes in the CPI will affect the price of TIPS by adjusting their principal value, but an increase in interest rates can have a huge impact on price due to the longer duration profile. This is an important feature to note, as credit risk is muted for both TIPS and US Treasuries, so the main driver of yield on these government bonds is credit risk. interest rate they carry.
The returns on these instruments can also provide information about market expectations of inflation through what is known as the break-even rate of inflation. This is calculated by taking the difference in yield between a nominal Treasury and a TIPS of the same maturity. When inflation averages higher than the break-even rate, TIPS are likely to outperform their nominal Treasury counterparts and vice versa. For example, the 10-year breakeven rate was 2.93% on March 14, 2022, well below the 7.90% increase in the CPI over the last 12 months that was announced earlier in the month. Theoretically, market conditions are ripe for TIPS and TIPS funds to thrive.
Let’s look at a couple of competitive offerings in the Morningstar category of inflation-protected bonds.
Vanguard Short-Term Inflation-Protected Securities Index (VTAPX) earns a gold rating from Morningstar Analyst thanks to its risk-aware profile and ultra-low fees. This index fund focuses on the shorter end of the TIPS market and therefore faces less interest rate risk than its peers. While this somewhat limits the fund’s upside potential relative to its peers, this trend should also boost the fund’s effectiveness as a long-term inflation hedge, as short-term interest rates are more correlated to the CPI than short-term interest rates. long-term rates. For example, when the 10-year Treasury yield rose to 2.45% from 1.51% from August 2016 to December 2016 and inflation expectations rose, the average pair lost 1.17% , while this fund gained 0.19%.
Pimco Royal Return (PRTNX) it carries an Analyst Rating of Neutral, although it is the only strategy in the category to earn a Process Pillar rating of High. (Its cheaper share classes, which have higher minimum investments, earn Silver and Bronze ratings.) The team employs macroeconomic strategies (driven by real growth, inflation, and country-specific analysis) and microeconomic themes (including CPI seasonality, on-the-run/off-the-run premiums, and implied inflation volatility) ) to position the strategy. Inflation-linked bonds typically dominate the portfolio, although the strategy may invest up to 20% in other sectors such as corporates and securitized rates. The approach has at times led to sizeable betting outside the index, setting it apart from its more restricted peers. This adventurous nature can cause the performance of the strategy to differ from the US TIPS market at times, although it has been successful in the long run. The fund outperformed the average performance of the inflation-protected bond category during the previous three-, five- and 10-year periods ending in February 2022.
Source: www.morningstar.com