Published: August 2021
I’ve been getting a lot of questions lately about how Treasury Inflation-Protected Securities or “TIPS” work in this type of environment, so I thought I’d write a quick article about it.
In this fairly inflationary environment of late, people are curious about how to protect their money and naturally TIPS seems like a decent option. In fact, they can be a decent option, and I have some TIPS myself.
However, they also have some major issues that investors need to be aware of.
How TIPS work
A US Treasury bill, note, or bond is a debt security issued by the US federal government.
For most types of Treasury bonds, you buy a bond by giving them a certain dollar amount of principal, receive interest payments over that bond’s maturity period, and then receive your dollar principal at the end. It doesn’t matter how much a dollar is worth in terms of purchasing power at that point; you get that many dollars back, period.
The problem, of course, is that the US and other countries have experienced periods of price inflation that really killed off the purchasing power of those bonds. At the end of the day, a dollar is just a piece of paper or a few bits in a computer that the government says have value, and it typically gets less valuable each year as supply increases.
The chart below shows the past 150 years of 10-year Treasury note performance, adjusted for the consumer price index. The blue line is the average Treasury yield for the year, and the orange line is the annualized inflation-adjusted return you received if you bought the Treasury and held it to maturity in ten years:
The 1910s, 1940s, and 1970s were not kind to Treasury holders. And with Treasury yields as low as they are, investors in this environment also don’t have much protection against an inflationary environment here in the 2020s.
So a Treasury Inflation-Protected Security or “TIPS” goes one step further and promises that you will recover your principal in inflation-adjusted dollars, should one of those highly inflationary periods occur.
With a TIPS, the principal is adjusted for inflation (measured by the consumer price index or “CPI”) and you will receive interest every 6 months, which also rises and falls with the inflation-adjusted principal. They are sold in terms of 5, 10 or 30 years.
So suppose you buy a $1,000 10-year TIPS that you agree will yield 1% per year when you buy it. That means you’ll get $10 a year in interest, and at the end of ten years, you’ll also get $1,000 back. However, unlike a regular Treasury note, that security will adjust for inflation. So, if inflation increases by 5% next year, the principal on the note will be adjusted to $1,050 and the annual interest amount will be adjusted to $10.50. Whatever the official CPI, your principal and interest will adjust over the term of the security.
If deflation (negative inflation) occurs, which is very rare, then the interest payment will also be adjusted downward. However, even if deflation occurs, at the end of the period you will still receive at least $1,000 back. In other words, you receive either the inflation-adjusted principal or the original principal back, whichever is greater.
Sounds great, right? Not always.
The problem with TIPS
If TIPS had no drawbacks, then of course they would be better than regular Treasuries. You get all the features of a Treasury security, plus inflation protection.
TIPS, of course, have two main disadvantages.
Disadvantage 1) Lower Yields
The first drawback is that TIPS offer lower yields than their counterparts without inflation protection.
At the moment, the normal 10-year Treasury yields about 1.3%. Meanwhile, the 10-year TIPS note yields around -1.1%. Yes, that is a negative return.
Chart Source: St. Louis Fed
In other words, if you buy a TIPS and hold it until expiration, you are guaranteed to lose money against the consumer price index. That 10-year TIPS note will adjust according to the prevailing changes in the CPI, but in the meantime it will earn a negative interest rate. So you’ll be keeping up with official inflation, minus that negative rate. In exchange for lending your money to the government, the government promises to give you back less purchasing power than it gave you. Oh.
This also gives us some information about what the Treasury market believes the average inflation rate will be over the life of the note. If the normal 10-year Treasury yield is 1.3% and the 10-year TIPS yield is -1.1%, assuming a rational market, it tells us that market participants expect inflation to average the 2.4% over the next 10 years. That third variable, 2.4%, is the “inflationary equilibrium point”.
Chart Source: St. Louis Fed
This is where TIPS come in handy as an investment. If the Treasury market believes that inflation will average 2.4%, but it ends up being 6%, then TIPS will outperform the normal Treasury note over its term. It will still lose purchasing power thanks to its negative yield, but it will lose less purchasing power than a regular Treasury note.
As an example, let’s say that inflation is higher than most people think and it turns out to be 6% on average over the next 10 years. 10-year TIPS would be fine; would keep that 6% inflation, but the negative return of -1.1% would offset it somewhat. However, a normal 10-year Treasury yielding 1.3% would do much worse; that gap between what it is yielding and what inflation ends up being, is much greater.
So if you expect inflation to end up being higher than the market thinks, or want to hedge against the possibility of that happening, then it makes sense to have an allocation to TIPS in a bond portfolio. TIPS do not keep pace with inflation at current yields, but they protect you from the possibility of excessive inflation.
On the other hand, if inflation turns out to be lower than the Treasury market currently believes it will be over the life of the security, then TIPS will have underperformed their non-inflation-protected counterparts, thanks to their higher yields. Lower. If inflation ends up being only 1% for the next ten years, then you would have been better off buying regular Treasuries.
In short, regular Treasuries are a better hedge against deflation or disinflation, while TIPS can provide some measure of protection against excessive inflation. If inflation ends up averaging roughly where the Treasury market estimates it to be, then the two types of securities will roughly break even.
Also, if you are a trader and willing to sell it before it expires, you might be able to make a little money off the principal profits. If the yield drops while you hold it, that means the bond itself has gone up in price and you could resell it to someone else. That’s also true of other types of Treasury bonds, of course.
One of the problems with the Treasury market is that it is a “managed” market. The US Federal Reserve creates new bank reserves to buy Treasuries, including TIPS, in part to ensure that yields stay low and that oversupply of Treasuries doesn’t overwhelm private demand for them and cause problems. of liquidity. That helps keep Treasury yields, including TIPS yields, low. This is good for the borrower (the US government), but not good for bondholders, who face negative inflation-adjusted rates.
Disadvantage 2) Dependence on the official CPI
The other downside of a TIPS is that it relies on the government’s measure of inflation, the consumer price index, or “CPI,” which is relatively accurate.
There are many ways to look at it, but in general, the evidence suggests that the CPI does not keep up with actual inflation. In particular, capital goods or premium goods, or labor-intensive services, such as a quality single-family home, a gold coin, a premium cut of beef, child care services, medical care and other similar things that have a degree of scarcity. and they are difficult to replace, they tend to exceed the official CPI.
A funny way to describe it is that things you really need to buy or want to buy go up much faster than CPI, while things that are easily automated, offshored or digitized tend to go up slower than CPI or even go up. . drop in price over time. Also, everyone has their own unique inflation basket anyway, since everyone has a different proportion of the goods and services they buy.
Both drawbacks overlap. If a TIPS performance is negative, it will not be able to keep up with the IPC. If the CPI doesn’t keep up with the basket of goods you want to buy, particularly capital goods and premium goods/services that are difficult to mass-produce, it will underperform actual inflation even more. Thanks for playing, please try again next time.
final thoughts
The short summary here is that TIPS are an inflation hedge, but an imperfect one.
They have negative returns right now and depend on the government measuring inflation correctly. Within a bond portfolio, they can protect capital in a highly inflationary environment better than many types of fixed income securities, but since the yield is negative, they will still lose some money due to inflation.
In other words, owning negative yield TIPS in a highly inflationary environment is like earning the NIT. Yes, it’s better than losing the NIT, but it’s not as good as being in NCAA March Madness.
If there is really high inflation over a long period of time, some basket of hard/scarce assets like gold, silver, industrials, oil, certain types of real estate, and bitcoin are likely to do better than TIPS . TIPS, however, have much lower downside price risk than most such assets. TIPS are a low-volatility way to hedge against excessive inflation, rather than a way to profit from inflation, unless you are actively trading TIPS.
The main type of environment in which you’d like to own some TIPS is when you’re worried that inflation might outperform consensus expectations, but you’re not sure about that, or you’re worried about valuations or the volatility of some other inflation. -Hedging assets. In other words, if you’re willing to lose a point or two to inflation per year for a certain portion of your portfolio in exchange for relative safety, then TIPS could be you.
If we have a highly volatile period of asset price declines, you could sell some TIPS and buy some of those other types of assets when they are cheap, and in that environment, owning some TIPS would have been helpful. They are a useful rebalancing tool.
For this reason, I believe that TIPS can guarantee a position within a diversified portfolio, but the investor must be aware of its limitations. They are less volatile than many “true” inflation hedges, but in return, they do not fully protect against inflation in all of its typical forms.
Investors can buy TIPS directly from the Treasury or they can buy TIPS ETFs. These are some of the big ones:
iShares TIPS Bond ETF (TIP) Schwab US TIPS ETF (SCHP) Vanguard Short Term TIPS ETF (VTIP) iShares 0-5 Year TIPS Bond ETF (STIP)
Shorter duration TIPS have lower volatility than longer duration TIPS, but also generally have lower returns.
Source: www.lynalden.com