Inflation-protected Treasury securities are often viewed as relatively quiet vehicles. As Treasury instruments, their credit quality is excellent and they often attract more conservative investors seeking a hedge against inflation risk.
However, this year’s turbulent market has been a stark reminder that TIPS are still subject to their own types of risk and can be especially vulnerable during periods of rising interest rates.
How TIPS work
TIPS were originally introduced in January 1997 and are currently sold in five, 10 and 30 year maturities. Unlike other bonds, which generate returns in nominal terms, TIPS are designed to be a direct hedge against inflation. Its core value is designed to move up or down in line with the Consumer Price Index: if the CPI rises, its core value rises. If the IPC decreases, the value of the principal will decrease.
Although TIPS have fixed semi-annual coupons at the time of purchase, your interest payments will adjust based on changes in principal value. (In other words, if the principal amount adjusted for inflation increases, the interest payment will be adjusted to reflect the higher principal value.) TIPS are also designed to protect against deflation; Investors holding TIPS to maturity will receive either the adjusted principal amount or the original principal amount, whichever is greater.
TIPS performance quirks
While the mechanics are fairly straightforward, TIPS can be subject to some performance quirks. For one thing, they typically yield less than Treasury bonds with similar maturity dates; investors have to give up some return in exchange for protection against inflation. In some previous periods, like 2021, their returns have been really negative.
Also, TIPS yields do not track inflation perfectly. This is because yields depend in part on the inflation expectations built into a bond’s price at the time of purchase and how well they match actual inflation trends. The breakeven inflation rate, which measures the difference between the yield on a nominal Treasury and the TIPS yield for a bond with the same maturity date, is a key metric here. For example, as of July 27, 2022, the market was pricing in a breakeven inflation rate of 2.42% for the next 10 years and 2.61% for the next five years. If inflation turns out to be higher than those figures, investors will benefit from higher principal adjustments as well as coupon payments, but if it turns out to be lower, the premium price will not pay off.
TIPS can also be very sensitive to changes in interest rates. Like other bonds, its principal value declines during periods of rising interest rates, and that may or may not be offset by adjustments for higher inflation at the same time. Interest rate risk may be particularly pronounced for TIPS because issuance has historically been biased toward longer-dated bonds; as a result, most TIPS benchmarks have relatively long durations.
This risk has been very apparent so far in 2022, as shown in Exhibit 1 below. As 10-year Treasury yields rose from 1.52% at the beginning of the year to 2.78% as of July 27, 2022, TIPS posted negative total returns, with long-term TIPS suffering the largest losses. deep. As the exhibit shows, Morningstar’s US TIPS index is down almost 9% year-to-date, while the 10+ year TIPS index is down almost 22%.
These yields might surprise investors who expected TIPS to be a direct hedge against inflation, which has been running at an annualized rate of 9%. But over shorter timeframes, TIPS may actually be more sensitive to changes in interest rates than to changes in inflation. In other words, TIPS investors ignore interest rate risk at their peril.
TIPS has also exhibited some performance quirks during previous periods. In 2013, for example, the Federal Reserve announced that it planned to ease its quantitative easing policy by slowing the pace of Treasury bond purchases. This triggered a dramatic market reaction (a/k/a “gradual tantrum”), causing Treasury yields to rise in May and June 2013. The Morningstar index fell more than 3% during those two months, but the benchmark TIPS index lost more than twice that.
The sometimes erratic performance of inflation-protected bonds was also on display at the start of the global financial crisis in September and October 2008. Despite their excellent credit quality, TIPS lost nearly 12% of their value during those two years. months. It’s not exactly clear why this happened, although some observers speculated that it was a side effect of the market’s flight to safety and liquidity. TIPS are much less liquid than nominal Treasuries, which was a drag as investors fled any complex or thinly traded asset class.
Long-term performance trends
Despite their sometimes unpredictable performance, TIPS have generally proven to be a reliable long-term hedge against inflation. As shown in Exhibit 3, Morningstar’s US TIPS index has far outperformed inflation for the past 20 years.
But not all TIPS are the same. As shown in Exhibit 4, long-term TIPS have exposed investors to much greater risk than their short-term counterparts. Shorter-dated TIPS have led to lower total returns, but have also resulted in less volatility and significantly less downside risk. In general, TIPS with shorter maturities have produced the most attractive balance of risk and return, as measured by the Sharpe ratio.
Additionally, the short-term end of the TIPS spectrum has done a better job of hedging inflation, as detailed in a 2017 study by Vanguard. [1]. I found a similar pattern using Morningstar’s TIP indices over the period from 2000 to mid-2002. As shown in Exhibit 5, TIPS 1-5 year returns had the highest correlation with inflation when measured in monthly and annual periods.
conclusion
From a portfolio perspective, investors who want to hedge against inflation risk for a specific period of time may still be well served by holding individual TIPS with durations that match their time horizons. For investors buying individual bonds, TIPS can also be more attractive than I-Bonds because they are not subject to the same annual purchase limits ($10,000 per individual or trust for I-Bonds, in most cases).
But for most investors, it’s easier to hedge against inflation risk by buying TIPS through a fund, such as Vanguard Short-Term Inflation-Protected Securities. (VTAPX). Investors can also avoid taking unexpected risks and achieve more accurate inflation hedging by staying on the shorter end of the maturity spectrum.
[1] https://www.vanguard.ca/documents/tips.pdf
Source: news.google.com