Why Haven't TIPS Returns Kept Pace With Inflation?

March 29, 2023 Collin Martin
Although Treasury Inflation-Protected Securities returns have been disappointing despite soaring inflation, their principal values have risen and they're finally offering higher income.

Treasury Inflation-Protected Securities, or TIPS, are designed to protect investors from the effects of inflation. However, that hasn't been the case lately: Even as inflation rose to multi-decade highs, returns for TIPS were negative in 2022. What gives?

While TIPS can protect investors against inflation over the long run, they aren't necessarily a short-term "hedge," as recent experience has shown. Over short periods of time, price declines can offset the principal adjustment from rising inflation. That's what happened last year—yields rose so sharply that the decline in prices more than offset the surge in inflation.

We think the worst of the rise in yields is behind us. That should help reduce the risk of falling prices offsetting the inflation adjustment in the near term. Currently, TIPS yields remain near their highest levels in years. Investors can earn positive "real," or inflation-adjusted, yields today, and they can still make sense for investors looking to protect against inflation.

TIPS explained

TIPS are a type of Treasury security whose principal value is indexed to 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.

The coupon payments are based on a percent of the adjusted principal, so investors can benefit from higher income payments when inflation is rising, as well.

At maturity, however, a TIPS investor would receive either the adjusted higher principal or the original principal value at issuance. In other words, TIPS never pay back less than their initial principal value at maturity. The table below illustrates how the principal value and coupon payments would rise if inflation averaged 3% every year for a hypothetical five-year TIPS.

Principal adjustment and coupon payments for a hypothetical five-year TIPS

Chart shows the principal adjustment and coupon payments for a hypothetical five-year TIPS that was purchased for $1,000 on March 1, 2023. If inflation rose 3% annually, the principal repaid at maturity would be $1,159.

Source: Schwab Center for Financial Research.

The initial hypothetical TIPS principal value is $1,000. For simplicity, this example shows an annual inflation adjustment for the principal value, although in reality the adjustment occurs twice a year. The annual coupon payment equals the fixed coupon rate multiplied by the adjusted principal value. Example is hypothetical, for illustrative purposes only.

TIPS yields are relatively high

TIPS yields are off their recent highs, but are still at levels rarely seen over the last 14 years or so. More importantly, TIPS yields are positive, meaning investors who hold individual TIPS can earn a positive inflation-adjusted yield regardless of the inflation rate.

TIPS yields are "real" yields, already accounting for inflation. The annual rate of inflation over the life of a TIPS ultimately would be added to the stated yield when held to maturity to come up with the annualized return. If inflation averages 3% for the next five years, for example, that 3% inflation rate would get added to the roughly 1.3% "real" yield that a five-year TIPS offers today, resulting in a nominal return of 4.3% annually. The higher (or lower) inflation comes in, the higher (or lower) that nominal total return would be. That can be an important concept for investors who are worried that inflation will remain very elevated for a while.

TIPS yields have rarely been higher over the last 14 years

Chart shows the five-year TIPS yield from March 2009 to March 28, 2023. Although down slightly from recent highs, the yield is still higher than it has been since 2009.

Source: Bloomberg, using weekly data as of March 28, 2023. US Generic Govt TII 5-Year (USGGT05Y Index).

The difference between TIPS yields and yields offered by traditional Treasuries is important to consider when evaluating TIPS, as well. That difference is known as the "breakeven inflation rate." It's the rate that inflation, as measured by the consumer price index (CPI), would need to average over the life of the TIPS for it to outperform a traditional Treasury. If the CPI averaged more than that inflation rate, investors would have been better off in a TIPS; if it were below, a traditional Treasury would have made more sense.

The five-year breakeven rate is shown in the chart below. At 2.4%, inflation would need to average 2.4% or more over the next five years for a five-year TIPS to outperform a nominal Treasury. That's well below the current rate of inflation, and the recent disinflationary trend appears to have stalled. Annualizing the recent monthly changes in the CPI, inflation is still in the 4% area. A 2.4% breakeven rate is at the high end of the 14-year range, however, so it's high by historical standards.

Inflation likely peaked in 2022, but we don't expect it to suddenly drop to the sub-2%, pre-pandemic levels. It likely will be a long and bumpy road until it reaches the Fed's target. With that outlook, TIPS can make sense for investors looking for inflation protection now.

Five-year TIPS breakeven rate

Chart shows the breakeven inflation rate for a 5-year TIPS from March 2009 to March 28, 2023. The rate was 2.4% as of March 28th.

Source: Bloomberg, using weekly data as of March 28, 2023. US Generic Govt TII 5-Year (USGGBE05 Index).

Negative total returns explained

TIPS total returns are negative over the last two years. As of March 27th, 2023, the 12- and 24-month total returns of the Bloomberg U.S. TIPS Index were -7.2% and -1.7%, respectively.

Those returns likely caught many investors off guard, given the multi-decade-high rates of inflation lately—the 12-month change in the CPI has been above 6% or more for 17 straight months.

TIPS principal values have risen accordingly. Whether you hold individual TIPS, or you invest in a mutual fund or exchange-traded fund (ETF) that holds TIPS, the principal values are all likely up. The chart below illustrates how the inflation-adjusted principal value of a TIPS issued in April 2021 has risen since it was auctioned.

Note that this is simply the principal value. It does not consider any price changes in the secondary market. But this highlights how TIPS can still protect against inflation, especially if held to maturity.

The inflation-adjusted principal value of TIPS have generally risen lately

Chart shows the current inflation-adjusted principal of a TIPS with a 0.125% coupon rate that matures on April 15, 2026. The TIPS' starting value was $1,000 in April 2021 but had risen to about $1,140 by March 27, 2023.

Source: Bloomberg, using daily data as of March 27, 2023.

Treasury Inflation Protected Security, 0.125% coupon rate, April 15, 2026 maturity date (91282CCA7 Govt) and US Inflation Indexed CPI Ratio 5-Year Bonds Issued April 2021 (CPIRAPR21 Index). The line in the chart represents the inflation-adjusted principal value, using the CPI index ratio for this TIPS multiplied by its starting value of $1,000.

One note on the chart above: The inflation adjustment is based on the monthly change in the CPI, but there's a lag from when each reading feeds into a given TIPS. For example, the change in a given month's CPI isn't reported until the middle of the following month, and there's a delay from when it gets passed along to a given TIPS. That's why the line above flattens out for a short period of time beginning in early September 2022 as there was no change in the July 2022 CPI.

TIPS total returns have been negative because TIPS prices have fallen more than the principal values have risen. TIPS are still bonds, and they are still subject to same inverse relationship between their prices and yields that all bonds are subject to. TIPS yields surged in 2022, like most bond yields, sending their prices sharply lower.

The chart below illustrates this phenomenon. The blue line represents the price of this TIPS in the secondary market; the red line multiplies that price by the TIPS's inflation index ratio.

The price of this TIPS is down roughly 13% since it was issued in April 2021. (Note that this TIPS was issued at a premium price because it had a negative yield at issuance.) From April 2021 through February 2023, the most recent CPI reading we have, the CPI is up roughly 13%. That's why the red line is now close to its starting point from April 2021—the inflation adjustment has been offset by the price decline. This is just one example of a TIPS, however, and each TIPS has its own inflation index ratio and secondary market price fluctuations.

TIPS secondary market prices compared to its inflation-adjusted price

Chart shows the secondary market price for a five-year TIPS maturing on April 15, 2026 with a 0.125% coupon rate, compared with its inflation-adjusted price. The inflation-adjusted price is higher.

Source: Bloomberg, using daily data as of March 27, 2023.

Treasury Inflation Protected Security, 0.125% coupon rate, April 15, 2026 maturity date (91282CCA7 Govt) and US Inflation Indexed CPI Ratio 5-Year Bonds Issued April 2021 (CPIRAPR21 Index). The blue line represents the secondary market price of the TIPS, while the red line multiplies that by the inflation adjustment.

Individual TIPS vs TIPS ETFs

Investors can consider holding individual TIPS or through a mutual fund or ETF. There are pros and cons to each approach, but lately some TIPS ETFs have omitted their monthly dividends. That might have caught some investors off guard, so it's important to understand how TIPS ETF distributions work.

There are several factors that determine if a TIPS ETF can make a monthly distribution, as well as the size of that distribution, including the accrued interest earned each month, any premium amortization or discount accretion of the underlying holdings, the inflation adjustment, and the ETF's net expenses. Therefore, TIPS ETFs are not typically considered a suitable investment for investors who are seeking consistent monthly income from their investments.

What to do now

Consider TIPS if you're looking for long-term inflation protection. With real yields well above zero, investors can finally earn higher income with TIPS while also helping protect against inflation over the long run.

We also think the worst of the price declines are behind us. While it's been a difficult two years for TIPS investors, we don't expect Treasury yields to rise much further, if at all. With that outlook, TIPS prices might not fall much further, and they could actually rise in value if yields continue to fall as they have so far this year.

For individual TIPS holders, any potential price declines might not matter if they're held to maturity. For investors who invest in TIPS through ETFs or mutual funds, the value of the funds can fluctuate, but that doesn't mean you need to abandon your holdings. If yields rise and the funds rebalance, investors may be rewarded with higher income payments to help offset potential price declines, while additional inflation increases would result in positive principal adjustments to the underlying holdings.

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Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

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