Friday, June 25, 2021

Treasury Inflation Protected Securities (TIPS): What You Should Know

Inflation continues to be a concern these days, and many investors are looking for investments that can keep pace with, or hopefully beat, the rate of inflation. As a result, Treasury Inflation-Protected Securities, or TIPS, have become a popular investment option.

But investing in TIPS isn't always straightforward. They have many unique characteristics that can make the investing experience a bit confusing. Here are answers to some of the most frequently asked questions about the TIPS market:

1. What are Treasury Inflation-Protected Securities?

Treasury Inflation-Protected Securities, or TIPS, are a type of U.S. Treasury security whose principal value is indexed to the rate of inflation. When inflation rises, the TIPS’ principal value is adjusted up. If there’s deflation, then the principal value is adjusted lower. Like traditional Treasuries, TIPS are backed by the full faith and credit of the U.S. government.

Although there are many measures of inflation, TIPS are referenced to one specific index: the Consumer Price Index, or CPI, a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services, published monthly by the U.S. Bureau of Labor Statistics.

2. Will TIPS coupon payments fluctuate with the level of inflation, as well?

Yes. Just like traditional Treasuries, TIPS have fixed coupon rates and make semiannual interest payments. While the coupon rates are fixed, the actual coupon payments can fluctuate based on the underlying principal value. The table below provides a hypothetical look at a TIPS principal value and coupon payment based on a constant 2% rise in inflation.

How TIPS principal values and coupon payments can adjust to inflation.

Source: Schwab Center for Financial Research. The annual coupon payment equals the fixed coupon rate multiplied the adjusted principal value. Note that the initial TIPS principal value is $1,000 and TIPS coupon payments are actually paid on a semiannual basis, not an annual basis like this example illustrates. Example is hypothetical, for illustrative purposes only.

3. What sort of yields do TIPS offer today?

Most TIPS yields are negative today. While that might surprise many investors, consider the yields of nominal (non-inflation-protected) Treasuries. The 10-year Treasury yield is still positive at 1.5%, but after the rate of inflation is accounted for, that inflation-adjusted yield is below zero, as well.

All TIPS yields are below zero

Source: Bloomberg, as of 6/17/2021. US Treasury Inflation Indexed Curve (YCGT0169). Past performance is no guarantee of future results.

4. TIPS yields are negative? Doesn’t that mean investors would lose money?

Not necessarily, because nominal returns can still be positive. A nominal return doesn’t account for the effects of inflation, while a “real” total return incorporates the effect of inflation.

By investing in an individual TIPS with a negative “real” yield and holding that TIPS to maturity, an investor would be locking in a loss relative to inflation. In this case, TIPS can help the investor keep pace with inflation, but not beat inflation.

Nominal total returns can still be positive, however. For example, let’s assume a 10-year TIPS has a real yield of negative 0.9%. If inflation averaged just 1% per year, the nominal total return on this TIPS would still be positive, as the annual inflation adjustment would offset that annualized negative real yield. The higher inflation goes, the higher the nominal total return of a TIPS can go; the same can’t be said for the total return of a traditional Treasury.
5. How can I compare TIPS to traditional Treasuries?

Breakeven rates. A breakeven rate is the difference between the yield of a TIPS and the yield of a traditional Treasury of a comparable maturity. That difference is what inflation would need to average over the life of the TIPS for it to outperform the traditional Treasury.

For example, a 10-year TIPS offers a yield of roughly negative 0.8% today, compared with a 1.5% yield for a traditional 10-year Treasury. That difference is 2.3% (note that the TIPS yield is negative). If the CPI were to average more than 2.3% per year for the next 10 years, then that TIPS would provide a higher total return than the traditional Treasury. If inflation averaged less than 2.3%, then the traditional Treasury would outperform the TIPS.

When evaluating TIPS, the breakeven rate matters just as much as your outlook for inflation. Breakevens have fallen from their recent highs but are still elevated compared to history—the average 10-year breakeven rate since inception is exactly 2%.

10-year breakeven rates are near their 10-year highs

Source: Bloomberg, using monthly data as of 6/17/2021. US Breakeven 10 Year (USGGBE10 Index). Past performance is no guarantee of future results.

6. Would an investor beat inflation with TIPS?

Not if the investor purchased individual TIPS with negative yields and held them to maturity. For investors who purchase individual TIPS, the negative yields mean that they are essentially locking in that negative yield regardless of how high (or low) inflation goes. Even if inflation surges, the TIPS principal value is simply rising by the same rate as inflation, but not enough to offset the premium the investor paid (that premium that resulted in a negative yield.)

It also depends on the time horizon. With negative yields, it’s still possible for returns to beat inflation over the short run. Whether one holds individual TIPS or invests using a mutual fund or exchange-traded fund (ETF), total returns over short investing horizons can beat inflation. Although past performance is no guarantee of future results, note that in the 12 months ending May 31, 2021, the Bloomberg Barclays U.S. TIPS Index delivered a total return of 7.1%, even though the starting yield was negative.

7. If inflation rises sharply, will TIPS perform well over the short term?

Not necessarily—TIPS can offer inflation protection over the long run, but over the short run they can still underperform if yields rise. TIPS prices can fluctuate in the secondary market, and their prices and yields move in opposite directions. If TIPS yields rise due to a rise in inflation, their prices would fall.

In other words, TIPS can perform poorly over short periods of time even if inflation is surging, because the price might fall more than the principal is adjusted upward.

For that reason, we stop short of calling TIPS a good inflation “hedge,” especially over the short run. Over the long run, however, TIPS are one of the most straightforward ways to protect against inflation.
8. What’s the best way to invest in TIPS?

You can invest in TIPS either by holding individual bonds, or through a mutual fund or ETF. There are pros and cons to each approach. By holding individual bonds, you can plan to hold to maturity, meaning any short-term price fluctuations might not matter. Individual TIPS also can be good planning tools. While the amount at maturity isn’t totally known in advance, given the principal adjustments, investors can expect a return of at least the original $1,000 principal plus or minus the principal adjustment.

With a mutual fund or ETF you can get more diversification than might be achieved by buying individual TIPS yourself, and usually at a low cost depending on the fund. You also get the benefit of professional management, and potentially better pricing on the bonds than you might get by investing in individual bonds yourself. Mutual funds and ETFs don’t usually have a maturity date, so their prices or net asset values (NAV) will fluctuate, and there’s no certainty about what that price or NAV will be at a point in the future. When using mutual funds or ETFs to invest in TIPS, the fund’s yield can be distorted due to short-term fluctuations in the CPI. Very high yields that don’t match the yield of the underlying securities are likely attributable to a short-term rise in the rate of inflation and might not be repeated.
What to do now

TIPS are worth considering today, especially for those investors worried about inflation. However, in periods when inflation expectations fall, TIPS may underperform other fixed income investments.

Despite their current negative yields, TIPS are still one of the most straightforward ways to protect against inflation over the long run. For investors who currently have an allocation to high-quality, highly rated bond investments like Treasuries, but no exposure to TIPS, it makes sense to consider shifting some of that exposure to TIPS to help protect against long-term or unexpected surges in inflation.

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