Last week, inflation was reported to have hit its highest level in 40 years, posting a much stronger-than-expected rise. But inflation-protected bond funds have racked up losses, extending declines since the start of the year. What gives?
Simply put, investors are getting a lesson in the dynamics of the Treasury Inflation-Protected Securities market. Just because inflation is high and rising doesn’t mean a TIPS fund is going to make money. It can easily be the opposite. Often what matters most is what is expected to happen to inflation in the coming months, quarters, and years.
“This is an area where it seems simple and obvious: why not buy them if inflation is rising?” says Eric Jacobson, fixed income strategist at Morningstar’s managers’ research group. “The answer is that the market had anticipated that this would happen.”
Currently, while inflation readings have been heating up, investors are also expecting the Federal Reserve to take more aggressive action to put out the fire. “With the TIPS sell-off, the market is not reacting to inflation news, but to expectations of Fed strength,” says Jacobson.
This is being reflected in negative returns in TIPS funds so far in 2022. The iShares TIPS Bond ETF (TIP) it is down 4.5% so far this year, having returned 5.7% in 2021.
Among the actively managed TIPS funds, one of the largest, the American Funds Inflation Linked Bond Fund (BFIAX)it is down 3.7% in 2022 after a 3.8% return last year.
There is still more to the story that investors need to understand in order to make the best use of TIPS in a portfolio, including understanding what TIPS say about the expected level of inflation, “real returns” and exposure to changes in Interest rates.
How do TIPS work?
Most traditional bonds offer a fixed periodic interest rate until maturity, at which time the owner, whether an individual or a mutual fund, also receives a repayment of the security’s face value. To a large extent, traditional bond yields take into account expected inflation. The problem is that, over time, inflation will still eat up the value of that bond. That’s especially a problem for long-term bonds.
TIPS solves that problem by adjusting the amount owed to investors based on changes in the consumer price index. This means that investors are paid more as inflation increases. If the IPC rises by 5%, the amount that investors receive will also increase by 5%. (A more complete explanation of TIPS and TIPS mutual funds can be found here.)
TIPS have been around for about 25 years, but the current episode of inflation is the worst since the early 1980s. At the same time, inflation has risen in an extremely short period of time, driven by the unusual circumstances of the troubles. of the supply chain caused by a pandemic that arise from a recession. That is creating an environment unlike any seen by TIPS investors to date.
During 2021, TIPS was the best performing major sector in the US bond market. The Morningstar US TIPS Index rose 5.7% last year, while the broad Morningstar US Core Bond Index lost 1, 6%.
Most of that rally in TIPS took place in the second half of 2021 as the recovery from the pandemic recession took hold and the first signs of supply chain concerns emerged. That led to a flood of money from investors in TIPS and inflation-protected fund strategies in general.
The Fed changes gear
The change in the TIPS yield in early January coincided with a shift by the Fed to take more aggressive action to raise interest rates and withdraw bond purchases it had been making to pump money into the banking system during the recession. . Since the beginning of the year, the US TIPS index has lost 4.2%.
“I would put it on the shoulders of the Fed and other central banks changing policy,” says Steve Rodosky, managing director and portfolio manager at PIMCO. “Expectations have gone from nothing or very little on the policy rate front in 2022 and 2023 to more than four increases for calendar 2022.”
One way to see the impact of changes in expectations on inflation and the Fed is to track the so-called break-even rate. This rate, the difference between the nominal 10-year Treasury yield and the yield on the 10-year Treasury Inflation-Protected Securities, represents the market’s expectation of what inflation will be 10 years from now.
Over the course of 2021, the 10-year breakeven rose from 2% to 2.7%, reflecting expectations of higher inflation. The 5-year breakeven registered 2% at the beginning of the year to a maximum of 3.2% in mid-November. When the December and January inflation reports came in hotter than expected, they showed that inflation is proving stiffer than many economists predicted. At first glance, that would have suggested continued upward pressure on inflation expectations.
But that has not been the case. The 10-year breakeven has fallen again to 2.4% and the 5-year breakeven to 2.8%. While still above where they were a year ago, those levels are returning to the Fed’s long-term inflation target of 2%.
These readings show that “apart from the anticipated expectations of high inflation, the world expects a very subdued inflation environment after that,” says Rodosky, who is manager of the $12 billion Pimco Real Return Fund. (PRRIX).
For TIPS, those declining expectations of future inflation are translating into expectations of lower future inflation adjustments and, as a result, lower prices.
Headwinds Fof increasing returns
Another hurdle for some TIPS investors has been the rise in regular Treasury yields. The 2-year US Treasury bond yield jumped to almost 1.4% from 0.7% at the start of the year, while the 10-year bond yield hit 2% last week from 1.5%. Both changes are substantial moves in a short period of time. Despite the protection against inflation, a general increase in the level of interest rates will still be transmitted to the TIPS market, putting downward pressure on prices.
For this reason, Jacobson says that when bond fund managers and traders want to hedge against, or bet on, an impending rise in inflation, they will use short-maturity TIPs that are less affected by changes in interest rates. For example, the TIPS bond due in July 2022 has risen in value so far this year, even as longer-dated TIPS have sold off, says Jacobson.
Another component has been an increase in what are known as “real returns.” Generally speaking, a real yield is the yield on a bond minus the rate of inflation. Since the start of the pandemic, real TIPS returns have been negative. That means that once investors factor in the effects of inflation on their returns, even with the inflation protection offered by TIPS, investors would essentially be losing money on their investment.
Put another way, after inflation, “the premium you paid on that bond is so high that you won’t earn enough income between now and the bond’s maturity to offset it,” says Jacobson.
What quantitative adjustment means for TIPS
One of the reasons real TIPS yields have been negative is that the Federal Reserve has been buying large amounts of US Treasuries as part of its efforts to support the economy, an action known as expansion. quantitative or QE.
“You had investors moving into the asset class” looking for inflation protection, Rodosky says, “looking for the same bonds that the central bank was already buying.”
Recently, real returns have been on the rise. In addition to changing inflation expectations, the Fed’s move away from the market is removing a massive source of demand that had pushed yields lower. Fed officials have begun discussing reducing the amount of bonds it holds, as opposed to QE, a step known as quantitative tightening. “Since 2020, the fringe buyer of a lot of fixed income has been the Fed,” Rodosky says. That is letting traditional market participants set prices and are demanding higher yields.
What’s next for TIPS?
The question for investors begins with the role TIPS play in a portfolio. If it’s simply part of a longer-term asset allocation, as it would be, dollar cost averaging over time means not having to worry about current valuations.
But for a more tactical approach, the question revolves around what TIPS are currently pricing in for future inflation versus what an investor expects to happen. “You want to buy TIPS when the break-even rate is lower than your inflation expectations,” says Jacobson.
Looking back at breakeven rates, the TIPS market is priced at 2.8% inflation over the next five years.
Pimco’s Rodosky sees an opportunity for investors to hedge against the possibility of inflation being even stronger than it has been. “The market is priced in for a fairly rapid reversal of CPI levels to where we are ending 2022 and entering 2023 in a 2.5 range,” he says.
These expectations are based on the idea that once supply chain issues are resolved, inflation trends will revert to pre-pandemic dynamics, where globalization led to low wages and costs and fiscal austerity in major economies kept a brake on economic growth, says Rodosky. Another result could be that the pandemic has altered the history of globalization and that households have a considerably higher pent-up demand in the last two years than is being taken into account. Rodosky says that if that’s the case, “the cost of insurance is pretty low right now. ”
Source: www.morningstar.com