The hard truth about TIPS

what you need to know

Treasury inflation-protected securities are a common target-date fund holding that millions of workers use to save for retirement. A healthy couple following the 4% rule has an 80% chance of outliving the savings invested in TIPS at current rates. Advisors may think they can get better fixed income returns elsewhere, but the rewards for taking risk are small in this inflated market.

According to the Investment Company Institute, 52% of American workers are saving for retirement in date-specific funds.

The most popular Vanguard family of target date funds places 20% of a worker’s retirement savings in inflation-protected Treasury securities at age 72. Today, the five-year TIPS yield is -1.91%. In five years, the investor will earn $908 in purchasing power for every $1,000 invested in TIPS today.

Some advisers will look at today’s TIPS rates and believe they can take wealth out of a TDF, invest it in other bonds and get a higher return while charging an AUM fee. Believing otherwise means acknowledging an investment reality that many advisers have yet to accept.

This is the problem with TIPS.

TIPS and the 4% rule

The so-called 4% rule assumes that an investor can maintain an inflation-adjusted lifestyle equivalent to 4% of their initial savings at retirement. A retiree who buys $500,000 in TIPS in his 65the birthdays you could withdraw $1,666 a month of actual expenses ($20,000, or 4% of $500,000, per year) up to a couple of months after your 86th birthday. Of the 20% of the savings that a retiree invests in TIPS at current rates, this money will last 21 years if they follow the 4% rule.

Healthy couples have more than an 80% chance of outliving the savings invested in TIPS at current rates if they follow the 4% rule.

It is easy to focus on the negative real performance of TIPS as a way to dismiss their value as an investment. But TIPS are really a combination of two assets: a Treasury bond and an inflation hedge. Inflation hedging gives investors the ability to lock in a rate of inflation on their Treasury bond investments over time.

For example, the yield on a five-year Treasury bond is currently 1.27%. By choosing TIPS instead of a nominal Treasury, the investor can lock in an inflation rate of 3.16%. 3.16% is primarily the market’s expectation of the average inflation rate over the next five years, but it also represents the value investors are willing to place on certainty.

Federal Reserve economists find that the inflation risk premium has varied over time, but on average it is around 10 basic points (0.1%). In other words, investors get only a small bonus for taking on inflation risk instead of passing it on to the government.

In fact, investors who are simply willing to acknowledge the reality of negative real returns on safe bonds may receive a premium for buying inflation protection. Larry Swedroe, research director at Buckingham Wealth Partners, suggests using the Federal Reserve Bank of Philadelphia’s Livingston Survey of inflation forecasts by economists in industry, government, banking, and academia as a reasonable estimate of expectations. of inflation.

The most recent survey pegged short-term inflation expectations at 3.7%, which is higher than the spread between TIPS and Treasuries. This is not the first time the spread has signaled that investors could be paid to buy inflation insurance.

Economists such as Boston University professor Zvi Bodie argue that TIPS are particularly valuable to retirees because they remove a significant source of lifestyle risk for a modest cost in expected average spending.

In other words, 0.1% is a small price to pay for lifestyle insurance. David Blanchett, head of retirement research at PGIM, which offers a target date investment (the DayOne series) that adds TIPS to its retirement portfolio, believes TIPS provides value to retirees even at current rates.

“While TIPS yields are negative, explicit inflation protection may be especially valuable to certain investors, especially retirees, who want an investment that tracks the underlying risk of their spending needs.” For Blanchett, the annual retirement expense should be viewed as a liability, and a fixed-income investment should be judged on its ability to meet the post-inflation lifestyle.

“Sure, there is a ‘cost’ associated with having TIPS, but the benefit, like having other forms of insurance, is that if inflation is high, the investor is covered,” says Blanchett. “While the relatively high spread against nominal Treasuries may make them unattractive to some investors, there are certainly others who will be more than happy to buy them on the assumption that yield differences accurately reflect expectations around risk. ”.

Return to basic

It’s worth going back to basic financial theory to understand why investors take risks. In general, investors prefer certainty to risk because they are risk averse. They will pay less for an asset that has the same expected payout (yield, dividend, capital gain) that is risky compared to an asset with a given payout.

Market risk aversion determines how much of a discount investors need to buy a risky asset. In other words, risky assets should be cheaper because people prefer certainty, and lower prices for the same expected payout mean higher returns on average.

Corporate bonds have purchasing power uncertainty and credit risk. TIPS removes both. If inflation continues to rise at 5% a year, the $1,000 invested in nominal Treasuries today will buy about $60 less than the $908 in five years. If inflation is only 2%, then the investor might have an extra $50 to spend.

The actual rate of inflation is unknown, so your client is faced with a range of spending possibilities over five years. Is that a risk they want to take with such a modest potential risk premium?

The enigma of the credit premium

The good news is that investors don’t have to buy Treasuries at all. They can invest in corporate bonds that have historically outperformed Treasuries by rewarding investors for accepting a credit premium.