For those that have received questions about the relevance of owning TIPS during periods of increasing inflation, I have broken down how they work and why we do not own them at this time.
Conclusion: why we do not currently own TIPS
1.) We do not anticipate annual inflation above 2.14% over next ten years (breakeven at parity)
2.) TIPS performance driven by factors similar to Treasuries
3.) TIPS are an expensive insurance; drastically underperform during periods of low inflation
As of right now, the breakeven inflation rate for a 10 year duration is an average of 2.14% annually (difference between Treasury and TIPS yields):
10 Yr. Treasury: 2.83%
10 Yr. TIPS: 0.69%
Breakeven: 2.14%
The implication is that an investor will purchase a TIPS bond if they believe that annual inflation over the next 10 years will be higher than 2.14%. In other words, TIPS act as insurance for long term inflation.
10- Year Breakeven Inflation Rate
10-Year Treasury Yield
How TIPS work:
An individual Treasury Inflated Protected Security is a government issued bond that is supposed to compensate investors for changes in CPI (inflation). A TIPS bond pays a coupon semi-annually with the dollar payout based on a fixed coupon percentage. However, as we witness inflation (or deflation) throughout the year, the theoretical principal of the bond fluctuates.
For example, a bond with a face value of $1,000 with a 3% coupon will originally make payments of $30. If CPI increased by 4% during year #1, the theoretical principal of the bond increases by 4% to $1040. The next payout is then based off of the $1040 (3% would be a payout of $31.20). You are essentially trading a known dollar payout for assurance of maintaining purchasing power over time.
The issue is that, while TIPS do provide inflation protection by adjusting principal, the drivers of returns are still similar to those of a nominal bond.
Performance of TIPS is driven by the following:
1.) Interest rate changes (longer the duration, the more IR movements have a negative effect)
2.) Expected Inflation (price get bid up or down by investors playing the breakeven rate)
3.) Actual inflation changes (principal value adjusted based on CPI changes)
By getting exposure to the asset class through a mutual fund or ETF, the breakeven is not an exact science as there is merely an average maturity for the ETF or fund. However, by reinvesting all payouts over time, the end effect of maintaining purchasing power should approximately bear itself out.
We need to remember that TIPS act as an insurance policy and, during periods of low inflation, returns can actually be negative and tend to drastically underperform the Barclays Agg.
5 Year Trailing Returns – TIPS vs. Agg
Peter Malone, CFA
Research Analyst
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