As headlines concerning inflation seem to be swirling in the news, investors may wonder if there is any way to protect against the risk of higher-than-average inflation. While many people may be familiar with a traditional U.S. Treasury bond, there is another type of fixed income investment offered by the United States government that has returns linked to the actual inflation experienced in the economy. These bonds are called Treasury Inflation Protected Securities, TIPS for short, and were introduced in 1997. By allocating a portion of an investor’s fixed income portfolio to this style of bond, it is possible to protect some of the portfolio’s purchasing power in the event persistently higher inflation materializes.
When you purchase a traditional U.S. Treasury security, you loan the government a principal amount, say $1,000, and get paid a semiannual interest payment, or coupon, for the life of the bond before receiving your principal amount at the maturity date. The cash flows for this security are easily known: if the coupon rate on a $1,000 bond is 2% annually, you would receive $10 every six months ($20 per year) and then recoup your principal amount at the end of the term. Since the bond is backed by the full faith and credit of the U.S. government, there is virtually no default risk concerning not receiving any of these payments.
With a TIPS security, however, that same $1,000 bond will have higher or lower cash flows based on the inflation that the economy experiences, as determined by the U.S. Consumer Price Index (CPI). If the inflation rate over the first year of the bond is 5%, the new principal amount of the bond becomes $1,000 * 105% = $1,050. Accordingly, the 2% annual payout gets bumped from $20 to $21 ($20 * 105%) because the coupon payment is now calculated on a larger principal amount. This adjustment is made annually over the life of the bond (TIPS are issued in 5-year, 10-year, and 30-year maturities). Since TIPS are also issued by the U.S. Treasury, they carry the same default risk—essentially zero—as a traditional Treasury security.
Because of this inflation adjustment feature, holding TIPS can be beneficial if actual inflation is higher than market expectations for future inflation. The notion of a breakeven rate is important to understand here, as a buyer of TIPS will receive a lower yield than a traditional Treasury up front in exchange for the inflation protection included over the life of the bond. Think of this as the cost of the high-inflation insurance that a TIPS bond provides. A TIPS breakeven rate calculation looks at the current yields on a TIPS security and a traditional Treasury with the same maturity and determines the average annual inflation rate that needs to materialize in order to make the returns of the two securities equivalent over that time period. If actual inflation is higher than the breakeven rate, the holder of the TIPS bond will have a higher return, holding all else equal. If not, the investor would have been better off buying a traditional Treasury. As of mid-June 2021, this breakeven rate on ten-year securities hovered around 2.25%.
The terminal principal value of a TIPS bond is guaranteed by the U.S. government to never be below the original principal amount, even if the economy experiences deflation (i.e. negative changes in CPI) over the life of the bond. While the semiannual coupon payments can be below the original amount if deflation occurs, the entire original investment, if buying a new TIPS bond, is protected from any losses if the bond is held to maturity.
While TIPS carry virtually no default risk, there is still interest rate risk just like with a traditional Treasury. As market interest rates rise, the value of an existing bond tends to fall because those coupon payments are worth less when higher coupon bonds are available in the new rate environment. If a new $1,0000 bond is now offering a 3% coupon instead of the 2% in the original example, the value of the bond paying 2% annually should justifiably be lower. The original bondholder still receives the 2% coupon, but another investor would pay less to buy that bond than for a new bond paying 3% coupons. However, the interest rate risk from investing in a TIPS bond can be less than a traditional bond because if market rates are rising due to higher inflation, the increased coupon/principal of the TIPS bond will offset some of the lost bond value from higher rates in the broad economy. An additional way to lessen this risk is to invest in shorter-term TIPS that are closer to maturity, which should suffer less in a rising rate environment because there are fewer remaining payments to be received.
Another risk to investing in TIPS is that the expected inflation will not materialize over the life of the bond. If the CPI inflation rate averages 2% over the life of the bond but the breakeven rate was 2.5% at the time of purchase, the bondholder would have been better off owning a traditional Treasury. For this reason, it is unusual to see a fixed income portfolio composed entirely of TIPS because that would represent a large bet on future inflation being higher than the current market expectations for inflation. By holding both TIPS and traditional Treasuries, a fixed income portfolio is better positioned for multiple inflation environments without making bold predictions on future inflation data. It is also more common to see a portfolio using a TIPS index fund instead of investing in individual TIPS bonds, as a TIPS fund of multiple bonds can balance some of this risk by making changes to the portfolio holdings over time at different levels of breakeven rates in the market.
It is also possible for an investor’s cost of living to change in a different fashion than the main inflation index in the United States, the CPI, which is used to adjust the coupon and principal of a TIPS bond. If a retiree is using TIPS to maintain the purchasing power of a fixed income portfolio but has living costs that are more heavily weighted toward health care or other expense types than the CPI weightings, the inflation-linked bonds might not provide adequate protection against sector-specific inflation related to a certain age or lifestyle.
There are pros and cons to including a TIPS allocation in a portfolio. While they can hedge against sustainable outsized inflation risk to the purchasing power of a portfolio, they can also underperform if expected inflation does not materialize in the economy. Thus, TIPS can add value to the fixed income portion of a portfolio as a diversifier and excess inflation hedge but should not be an exclusive fixed income holding for a well-balanced portfolio. Please contact us if you would like to discuss your fixed income holdings in more detail.
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