With inflation staying stubbornly high, investors are considering Treasury inflation-protected securities, or TIPS, once again. Does it make sense to buy TIPS for your client’s portfolio? The answer will depend on investor views on inflation, risk tolerance, time horizon and current bond allocation, among other variables.
Matthew Schaller, wealth counsel at Compardo, Wienstroer, Conrad & Janes.
When you buy TIPS, you are placing a bet or hedge against unexpected inflation because TIPS bonds and regular bonds are priced with current inflation expectations built in. When an investor buys TIPS, the face value will trade daily based on the current inflation rate. TIPS are priced based on current inflation expectations, which is why they have a lower yield than Treasuries (more on that later).
Last year, even when inflation was around, many investors rejected TIPS because it had a negative real return; for example, buying a $1,000 bond with the expectation of getting back $975. As interest rates on bonds rose, so did the TIPS space. Currently, you can secure a positive return, making the TIPS market attractive to investors again.
TIPS as an inflation forecaster
TIPS often make more sense for investors who believe (or fear) that inflation will remain stubbornly high for the next (whatever) years, or for those whose crystal ball tells them that their opinion on inflation is it is more accurate than that. of the bond market.
Recent data from the US Treasury Department may help explain current TIPS and market forecasts. On October 17, a 2-year TIPS yielded around 1.92%. For a 5-year TIPS, an investor could lock in a rate of 1.72%. At 10 years, the rate was 1.51%. Compare these rates to a Treasury with the same maturity. In October, a 2-year Treasury yielded 4.42%. By comparing the TIPS rate to the Treasury rate of the same maturity, investors can calculate the equilibrium inflation rate.
Or, put another way, since there are thousands of traders buying and selling based on their own forecasts, the breakeven rate can really be seen as the current inflation forecast for that time period.
For example, if an investor buys 5-year TIPS at the October 17 exchange rate and inflation averages 2% over the entire five years, the return on TIPS would be 3.72% (1.72% in the purchase + 2% inflation adjustments). In this scenario, the investor would have been better off buying a 4.18% Treasury bond. However, if inflation averages 3% over the next five years, then the investor’s return would be 4.72%, which is higher than the Treasury’s 4.18%.
TIPS as coverage
TIPS could also make sense for an investor who wants to get a slightly lower potential return now to guard against inflation being much higher than anticipated. Many investors tend to view TIPS as a great long-term hedge. The idea is that if you’re really worried about inflation, a 2-year TIPS won’t really provide much protection given its short time horizon. A 10-year TIPS would make more sense to address such concerns, and a case could also be made for a 5-year TIPS. Adding an inflation hedge component could be a great complement to an already well-established bonus scale, especially now for those worried about inflation.
TIPS are not magic and carry risks, especially interest rate risk. Just like with bonds, if someone buys TIPS and then interest rates rise, the TIPS will lose value. A TIPS purchased last year would fall just like other bonds, but because we are in a historically higher inflation environment, it would fall less than most other bonds due to inflation adjustments or repricing.
Another consideration is that due to this price revision, there may be taxes each year, even if the investor does not sell any shares. The IRS considers an increase in the value of TIPS to be income. This is known as “phantom income” and can affect an investor’s taxes. All things being equal, TIPS are better placed on a qualified account than a taxable account, but the tax impact shouldn’t be the only deciding factor here.