December 17, 2020
Brian Rehling, CFA , Head of Global Fixed Income Strategy
Considering TIPS as a 2021 inflation hedge? Not so fast
- Treasury Inflation-Protected Securities (TIPS) are inflation-indexed securities designed to provide a real return commensurate with U.S. inflation, plus a small added return.
- Duration (a measure of a bond’s interest rate sensitivity) is a significant factor in TIPS performance that many TIPS investors overlook.
What it may mean for investors
- While TIPS can prove effective in the right situation, we believe most retail investors will find TIPS to be a less than ideal inflation hedge.
Record fiscal spending, large debt numbers, and quantitative easing conjure fears of inflation for some. Investors looking for a solution to their inflation concerns may consider turning to Treasury Inflation-Protected Securities (TIPS). After all, TIPS are inflation-indexed securities designed to provide a real return commensurate with inflation, plus a small added return or loss based on market yields. This is in contrast to a standard “nominal” Treasury security in which the coupon and final maturity value are set at issuance—with no adjustment for inflation. While TIPS may have utility for some investors’ inflation concerns, we believe many retail investors likely will find that TIPS do not offer the inflation solution they are seeking.
Breaking down TIPS mechanics
Just like traditional nominal Treasury securities, TIPS are issued with a defined coupon rate that does not change throughout the bond’s life. However, the income an investor receives while holding a TIPS security will change over time as the underlying principal value adjusts depending on the index ratio. At maturity, a TIPS holder receives the original principal value multiplied by the index ratio. The index ratio is important because this is the “inflation protection.” New-issue TIPS initially start with an index ratio near 1.00. The ratio is then adjusted daily for inflation as per the non-seasonally adjusted consumer price index (CPI) for all urban consumers (CPI-U).
Simplistically, the market value of standard nominal Treasury securities fluctuates based on changes in market yield. TIPS, however, have two primary components that influence price—inflation expectations and market yield. Many investors focus on the inflation expectation component of TIPS while misunderstanding the power interest rate movements have on TIPS performance.
Our expectation is that U.S. inflation will move higher next year as the economy recovers. If inflation expectations also continue to move higher, an investor could expect TIPS to outperform a comparable nominal Treasury security. However, higher interest rates that often accompany high inflation likely would lead to a negative return for TIPS holders as rising rates push prices lower under such a scenario. The inverse relationship between bond price and bond yield holds true for TIPS. This relationship is most pronounced in longer maturity securities. Most TIPS tend to be longer duration securities. The strong influence of duration in TIPS returns can be seen in Table 1 – which demonstrates that TIPS total returns often fall between intermediate and long-term fixed income.
In the right situation
We believe TIPS can offer a substitute for nominal Treasury securities for those investors looking to provide some purchasing power protection to a Treasury portfolio. Investors looking for a high degree of predictability can buy a new-issue TIPS, hold to maturity, and have assurance that their investment will be indexed to CPI. Unfortunately, the current negative real yield environment implies a small negative return after adjusting for inflation over the life of a new TIPS security. Investors also should remember that these assurances come with an opportunity cost of potentially higher returns in other asset classes.
Important investment considerations
Given the variability of TIPS’ response to changes in inflation expectations and interest rates—along with tax considerations—the knowledge of a professional investment manager can add value. Investors may choose to invest in TIPS through their investment manager, through mutual funds or exchange-traded funds (ETFs), or through investment in individual TIPS holdings. When doing so, it is useful to understand the following tax considerations:
- Purchasing TIPS directly: A buy-and-hold investor who buys TIPS directly from the U.S. Treasury and holds the security to maturity can lock in a real return equal to the TIPS yield when the investor purchased the security. Investors selling individual securities before maturity would be exposed to market risk. If TIPS are held in a taxable account, the coupon payments are taxed at the ordinary income tax rate, and the principal adjustment (or index-ratio adjustment) also is taxed at the ordinary income tax rate. This occurs even though the investor has not yet received payment for the principal adjustment. The principal (or index-ratio adjustment) is known as “phantom income.” As a result of these unique tax consequences, it often can be beneficial to place TIPS in a tax-deferred or tax-free account.
- Purchasing a mutual fund or an ETF specializing in TIPS: If a mutual fund is purchased, it may be required to distribute the taxable income to the investor as a dividend (both coupon payment and principal changes resulting from the inflation adjustment). This can help to alleviate the “phantom income” problem, and tax reporting would be similar to that for other bond funds. Investors also have the option of reinvesting dividends in mutual funds to remain fully invested.
Our TIPS outlook for the current environment
For investors who want to incorporate inflation-protected securities such as TIPS in a portfolio, we favor including them as part of a traditional taxable fixed-income allocation in either short-term, intermediate-term or long-term taxable investment grade allocations.
We currently have an unfavorable position on the U.S. Treasury securities sector and a neutral position on the TIPS sub-sector. Breakeven inflation expectations have increased recently, and we could see this trend continue into next year. TIPS may outperform a nominal Treasury security of similar duration under such a scenario. Despite the potential to outperform a similar nominal Treasury security, the potential for higher interest rates could still lead to negative returns for TIPS investors under such a scenario.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity.
Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index is composed of the Bloomberg Barclays US Government/Credit Index and the Bloomberg/Barclays US Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.
Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index is composed of the Bloomberg Barclays US Government/Credit Index and the Bloomberg/Barclays US Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.
Bloomberg Barclays TIPS Index represents inflation-protection securities issued by the U.S. Treasury.
An index is unmanaged and not available for direct investment.
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