Inflation Is Rising: Time to Consider Treasury-Inflation Protected Securities?

Key Points

  • Treasury Inflation-Protected Securities (TIPS) can offer protection against inflation, as their principal values rise and fall with changes in prices.
  • While most consumer inflation measures remain below the Federal Reserve’s 2% target, they have been getting closer lately.
  • Breakeven rates have risen sharply since the election, but we still think TIPS offer an attractive entry point, relative to Treasury securities, for investors seeking inflation protection.

Inflation hasn't been a serious problem for investors for several years now. With the average annual inflation rate hovering below the Federal Reserve's 2% target since 2013, investors may not have been too concerned about a general rise in prices eroding the real return on their investments.

That could be about to change, though. Although inflation is still relatively low, it has been trending higher and we think the trend may continue. In some ways, this would be a return to form. The annual inflation rate averaged 4.1% from 1970-2015. Your investments would have had to return at least that much just to keep your portfolio treading water during that period.

That’s why we think investors should consider including an inflation-hedging component in their portfolios. Treasury Inflation-Protected Securities (TIPS) are one way to do this. TIPS offer protection against inflation, and we believe they are priced at an attractive level given the outlook for inflation over the next few years.

What are TIPS?

TIPS are a type of U.S. Treasury bond whose principal amount adjusts with inflation, as measured by the Consumer Price Index for All Urban Consumers, or CPI-U. When the CPI-U rises, so does the principal value of a TIPS. If prices contract, so does the value of a TIPS. When a TIPS matures, an investor receives either the adjusted principal or the original principal, whichever is higher.

But that’s not the only inflation protection provided by such securities: TIPS also pay a fixed rate of interest twice a year that is based on the fluctuating principal value. That means a TIPS investor would get larger interest payments if prices were rising, and smaller payments should deflation set in.

Like traditional Treasuries, TIPS are initially issued with a principal value of $1,000, and can have initial maturities of five, 10 or 30 years. To get a sense of how they work, imagine a five-year TIPS issued with a 1% coupon. If the inflation rate over the first year is 2%, its principal value would rise to $1,020 (a 2% increase in the initial $1,000 principal). As a result, the interest payment at the end of the first year would be $10.20 (the 1% coupon rate multiplied by the $1,020 adjusted principal).

Note that in a deflationary environment, a TIPS' principal could drop below its $1,000 initial value. But, as mentioned above, investors would still receive at least the $1,000 back at maturity. In other words, TIPS never pay less than the initial principal value at maturity. Investors who buy and sell in the secondary market should take caution, however: If deflation hit after you bought a TIPS in the secondary market, and you turned around and tried to sell it before maturity, it’s possible you might receive less than the initial principal value.

TIPS vs traditional Treasuries

So how do TIPS stack up against regular Treasuries? The first thing to understand is that TIPS tend to offer much lower yields to reflect the potential for a rising principal (and interest payments). So if you want to compare two securities of comparable maturities, you have to calculate how much inflation you’d need over the life of a TIPS for it to break even against a regular Treasury.

For example, if a 10-year TIPS offered a yield of 0.7% and a 10-year Treasury offered a yield of 2.6%, the 10-year breakeven rate (the difference between the two) would be 1.9%. If inflation is higher than the breakeven rate over the life of the TIPS, the return—assuming you hold the TIPS to maturity—would be higher than the return from a traditional Treasury with a comparable maturity.

Breaking even

TIPS breakeven rates today are slightly below their historical averages. The five-year breakeven rate is 1.8%, compared with a historical average of 1.9%, while the current 10-year breakeven rate of 1.9% is just below its long-term average of 2%.1 Remember, a lower breakeven rate means it takes less inflation for TIPS returns to match those on a comparable Treasury, and higher inflation can mean even higher returns.

Breakeven rates have risen recently, but they are still below the Fed’s 2% inflation target

Breakeven rates have risen recently, but they are still below the Fed’s 2% inflation target

Source: Bloomberg, monthly breakeven rates as of 12/15/2016.

TIPS breakeven rates have risen sharply since the Nov. 8 election, as the incoming administration’s fiscal and tax plans have raised both growth and inflation expectations. Meanwhile, inflation has been trending higher since the second half of 2015.

In November 2016, the year-over-year increase in the CPI-U was 1.7%. While that’s still below its long-term average—and below current breakeven rates—it was still higher than many of the monthly readings we saw in 2015, when the year-over-year change in the index hovered between –0.2% and 0.2% during the first nine months of the year.

Other measures of inflation are moving higher as well. The Personal Consumption Expenditures Index (PCE) was up by 1.4% on a yearly basis in October 2016. That index was also stuck in a rut throughout much of 2015, with most year-over-year readings coming in at 0.3% or below.

Meanwhile, core measures of inflation, those that exclude the volatile food and energy components, have also been moving higher, and some are even above the Fed’s 2% inflation target. The 12-month change in core CPI has above 2% in each month since November 2015, while core PCE has been above 1.5% since January 2016.

Most inflation measures have been gradually rising

Most inflation measures have been gradually rising

Source: Bloomberg. Monthly data as of 11/2016 for CPI and Core CPI, and as of 10/2016 for PCE and Core PCE. CPI is represented by the U.S. CPI Urban Consumers index; Core CPI, by the U.S. CPI Urban Consumers Less Food & Energy index; PCE, by the U.S. Personal Consumption Expenditures Chain Type Index; and Core PCE by the U.S. Personal Consumption Expenditures Core Price Index.

One factor that could push inflation higher is the recent rising trend in commodities prices. The more-than 50% drop in the price of oil from mid-2014 through mid-2015 helped pull the CPI-U into negative territory. Prices today are much closer to where they were one year ago, so low commodity prices should exert less drag on the inflation rate than they did in 2015.

The Federal Open Market Committee (FOMC) expects inflation to rise in the years to come. The median projections for both PCE and core PCE in 2018 are 2%, according to the FOMC Summary of Economic Projections. And according to Bloomberg, the consensus estimate for the 2017 change in the CPI-U is 2.3%.2 If inflation does indeed rise to that level next year, inflation protection through TIPS appears underpriced today relative to traditional Treasuries.

Tempered expectations

TIPS are still government bonds, meaning they come with many of the same risks and rewards of traditional Treasuries, including low, or even negative, yields.

Yields on TIPS with maturities of around three years or less are negative, while 10- and 30-year TIPS offer yields of 0.7% and 1.1%, respectively.3 Buying a TIPS at a negative yield doesn’t necessarily mean that the total return, if the TIPS is held to maturity, will be negative, since the principal amount and coupon payments can rise. In other words, there would have to be no increase in the value of the CPI-U index over the life of the TIPS for it to deliver a loss.

TIPS’ low coupon rates can be a concern for investors looking for more income. And lower coupons help increase a security’s duration—a measure of interest rate volatility—meaning their prices may be more volatile than those of traditional Treasuries when interest rates rise or fall. Like any other bond, the market value of a TIPS—whether held individually or through mutual funds or exchange-traded funds—can rise and fall with changing rates.

What to do now?

We think TIPS make sense today, relative to traditional Treasuries. Although breakeven rates have risen sharply since the election, the cost of inflation protection today is below the consensus forecast for inflation next year. If the trend in inflation continues to move higher, and the CPI-U rises to or above, 2%, we think TIPS should outperform traditional Treasuries in 2017.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call a bond specialist at Schwab anytime at 877-908-1072. 
-          Talk to a Schwab Financial Consultant at your local branch.

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