A reader asks:
Hey guys, please explain why an inflation-linked bond could have lost money this year with 9% inflation.
I’ve been getting this question a lot lately.
How is it possible that bonds that have an implicit inflation trigger are down almost 7% this year?
Treasury Inflation-Protected Securities (TIPS) are one of the most unusual assets in the investment universe.
They are relatively new and have some unique features when it comes to bonuses. They have been around in the UK since the 1980s, but the US government didn’t start offering them until the late 1990s.
The way they work is that the principal value of the bond is linked to the rate of inflation: when inflation increases, the principal value of the bond also increases.
But investors don’t get inflation-adjusted principal until maturity.1 Meanwhile, the economy can be all over the place, which means inflation, deflation, rising rates, falling rates and everything in between.
So while the inflation protection built into these bonds is unique, TIPS can be volatile down the road.
For example, the largest inflation-protected bond fund is the iShares TIPS Bonds ETF (TIP). This fund lost almost 15% in the fall of 2008:
Part of this had to do with the deflationary nature of the Great Financial Crisis, but Lehman Brothers had also used TIPS as collateral for some of its loans and became a forced seller of these bonds.
However, there are no systemic reasons for TIPS to sell off this year. The problem in 2022 is that TIPS act more like a bond than an inflation hedge.
You can see that in 2021, TIPS outperformed the aggregate bond market by a wide margin:
That made sense given that inflation was much higher than most expected.
I’m sure most investors assumed a similar pattern would repeat itself this year, but instead TIPS are down like normal old bonds.
Over the past year, the US inflation rate was 8.5%, but the TIP ETF is down 5%.
What gives?
There are a couple of reasons for this confusing performance.
The first is that TIPS help protect investors from unexpected inflation. Expected inflation is already priced into the yield relative to normal Treasury bonds. Therefore, I would expect TIPS to outperform when unexpected inflation rears its ugly head (as it did in 2021).
Investors began to price in higher inflation on these bonds, so the outperformance has dropped substantially this year.
But the biggest hurdle this year is rising interest rates. The yield on 10-year Treasury bonds has doubled from 1.5% in January to 3% now. When rates go that high, TIPS will act more like bonds than an inflation hedge.
This is especially true for TIPS of longer duration.
For example, the TIP ETF has an effective duration of 7.1 years.
Duration is simply a way of measuring interest rate sensitivity. A duration of 7 years implies that for every 1% movement in interest rates, the bond fund should go up or down 7% in price. This relationship has a few other variables, but that’s a good rule of thumb.
Since yields and prices are inversely related to bonds, the rise in yields has overshadowed the rise in inflation.
The simplest explanation for this year’s poor performance is that interest rates rose and inflation added to the pie more than last year. The good news for investors here is that rates are now higher; the bad news is that you need to eat some losses to get to this point.
There are ways to reduce the impact of interest rate changes on your inflation-protected bonds.
The Vanguard Short-Term Inflation-Protected (VTIP) ETF has an average duration of just 2.7 years, making it much less sensitive to changes in interest rates.
The US inflation rate first exceeded its long-term average of around 3% in April 2021. Take a look at how VTIP has performed against TIP since then:
Short-term TIPS have outperformed longer-maturity TIPS at the time and have done so with much less volatility. These bonds are outperforming because the inflation-indexed component is playing a larger role in their total return.2
So if you prefer less volatility and a closer relationship to those inflation-adjusted returns, short-term TIPS are an option.
I would be remiss if I didn’t mention Series I Savings Bonds here as well. These bonds are about as good as it gets when it comes to inflation protection without any interest rate risk (read here for more details).
Unfortunately, there is a limit in terms of how much you can invest in these bonds.
We talk about inflation-protected bonds and much more in this week’s Portfolio Rescue:
Josh Brown joined me to go over some questions about finding younger clients as a financial advisor, how young people should allocate their retirement funds, and pay off student loans with earnings from a selection of stocks from 10 stock markets.
Here is the podcast version of today’s show:
Other readings:
How Series I Savings Bonds work
1At maturity, you get either the greater of the original (par) principal or inflation-adjusted principal. That way, you have a floor if there is deflation during the life of the bond.
2The opposite will happen if/when rates fall again. So you would expect TIP to outperform because the bond component would carry a higher weight in total return.
Source: awealthofcommonsense.com