TIPS Can Help Protect Against Inflation, But Keep Your Expectations in Check

Inflation has been trending higher over the past few years. That can cause a problem for investors, as a rise in inflation can lower a portfolio’s “real,” or inflation-adjusted, return. Treasury Inflation-Protected Securities, or TIPS, are a type of government bond that is indexed to inflation, so they can help investors keep pace with a rising trend in prices. Although TIPS are designed to help investors keep up with inflation, the rate of inflation is just one of the factors that should be considered. When considering TIPS, the price of that inflation protection matters as well, and that price of protection has risen lately.

Before we dive into the relative attractiveness of TIPS compared to traditional Treasuries, let’s go over their basic characteristics first.

TIPS—the basics

TIPS are backed by the full faith and credit of the U.S. government, just like traditional Treasury securities. They have set maturity dates and make semiannual coupon payments.

The principal value of a TIPS is indexed to inflation. The coupon payments that TIPS make are based on that principal value. So while the coupon rate is fixed, the coupon payments can fluctuate. The index used for TIPS is the Consumer Price Index for All Urban Consumers, or CPI-U.

For example, assume that a 10-year TIPS is issued with a 1% coupon rate. If there were no inflation in the first year of issuance, that principal value would still be $1,000 and the annual coupon payment would be $10.

But let’s assume that in year two, inflation averaged 2%. At the end of year two, the principal amount of that TIPS would now be $1,020 and the coupon payment would be $10.20, a bit higher than the previous year. (TIPS make semiannual coupon payments, so this example is strictly for illustrative purposes.)

This helps TIPS protect investors against the effects of inflation, because they’ll be rewarded with a higher principal value at maturity (traditional Treasury bonds simply mature at their $1,000 par value) as well as growing coupon payments if inflation is rising. The opposite is true as well: In deflationary periods, the principal value of a TIPS will fall, resulting in smaller coupon payments. At maturity, however, a TIPS investor would receive either the adjusted principal or the original principal value. In other words, TIPS never pay back less than the initial principal value at maturity.

Investors who purchase TIPS in the secondary market should take caution, however. If deflation hits after you purchased a TIPS in the secondary market, it’s possible that the principal value could be less than the principal value when purchased.

Inflation has been rising

Inflation has been steadily increasing over the past few years. The latest year-over-year change for the Consumer Price Index (CPI) was 2.9%, its highest reading since early 2012 and above the 20-year average of 2.2%. It’s also well above the Federal Reserve’s 2% inflation target.

The CPI is at its highest level in more than six years

Source: Bloomberg, using monthly data as of 6/30/2018. Consumer Price Index for All Urban Consumers (CPI YOY Index).

It’s not just the CPI that’s on the rise—almost all inflation indicators have been climbing. Stripping out volatile food and energy prices, the “core” CPI is also above the Fed’s 2% target, rising by 2.3% in the 12 months ending June 2018. Even the Fed’s preferred measure of inflation, the Core Personal Consumption Expenditures index, touched 2% for the first time since 2012.

Breakeven rates—the price of inflation protection

The current level of inflation isn’t the only factor to consider when investing in TIPS. How much are you paying for that inflation protection that TIPS offer? That’s an important factor, as well.

One way to evaluate the relative attractiveness of a TIPS is to compare its yield to the yield of a traditional (non-inflation-protected) Treasury. TIPS generally offer lower yields than Treasuries, because their principal values (and therefore coupon payments) rise with the level of inflation. Because the principal value of a traditional Treasury is fixed, the effects of inflation can eat into an investor’s return.

The difference in the two yields is called the breakeven rate. The breakeven rate is what inflation (measured by the CPI-U) needs to average over the life of that TIPS for its total return to break even with the total return of the traditional Treasury.

For example, if a 10-year Treasury offers a yield of 3% and a 10-year TIPS offers a yield of 1%, then the breakeven inflation rate is 2%. If inflation averaged more than 2% over the next 10 years, then the 10-year TIPS would deliver a greater cumulative total return than the traditional 10-year Treasury. If inflation averaged less than 2%, then the traditional Treasury would deliver a greater total return.

Breakeven rates have come off their 2018 highs, but are still close to their four-year highs. However, even though breakeven rates have risen, they are still well below the most recent 2.9% reading of the CPI.

Breakeven inflation rates have risen over the past few years

Source: Bloomberg, using weekly data as of 7/24/2018. TIPS 5 Year Breakeven Inflation Rate (USGGBE05 Index) and TIPS 10 Year Breakeven Inflation Rate (USGGBE10 Index)

Manage your return expectations

Given the relatively high breakeven rates, it’s a bit expensive to be investing in TIPS for investors with short time horizons. We studied the relationship between the five-year breakeven inflation rate with the next-12-month relative performance of TIPS, as measured by the total return of the Bloomberg Barclays U.S. TIPS Index minus the total return of the Bloomberg Barclays U.S. Treasury Bond Index. Both indexes have similar average durations—5.5 for the TIPS index and 6.0 for the Treasury index—in line with the five-year breakeven inflation rate.

We broke down the study into regimes when the five-year breakeven rate was either above or below 1.85%, which is its average since inception. As the chart below illustrates, the next-12-month average relative return (TIPS relative to nominal Treasuries) has been relatively poor when the starting breakeven rate is above 1.85%.

High breakeven rates generally lead to low relative returns

Source: Schwab Center for Financial Research with data from Bloomberg. Monthly total return data for the Bloomberg Barclays U.S. Treasury Bond Index and the Bloomberg Barclays U.S. TIPS Index, and monthly breakeven data for the TIPS 5-Year Breakeven Inflation Rate (USGGBE05 Index). Next-12-month average total return using data from March 1998 through June 2018.

It’s not just relative returns that could be challenged over the short run. Rising inflation won’t necessarily help TIPS deliver high total returns for a few reasons, including:

1. Low absolute yields. Today, five- and 10-year TIPS offer yields of just 0.80% and 0.83%, respectively. So while they can benefit if inflation does rise, expectations need to be held in check because the real (inflation-adjusted) yields are paltry.
    
2. Rising yields can mean lower prices. TIPS are still bonds, meaning they are still sensitive to the inverse relationship between their prices and yields. So if yields rise, their prices can still fall, potentially more than the inflation adjustment. Keep in mind that TIPS principal amounts due at maturity aren’t affected by price and yield fluctuations in the secondary market.

What to do now

TIPS can help investors combat the impact of rising inflation, but for investors with a shorter investing horizon, it’s a bit expensive to be investing in TIPS today. However, for investors who have longer investing horizons and are worried that inflation may continue to rise, TIPS breakeven rates are still close to their long-term averages and below the current level of inflation, meaning they may help protect against inflation for the long run.