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TIPS Can Keep Pace With Inflation—but Curb Your Return Expectations

Key Points
  • Treasury Inflation-Protected Securities, or TIPS, can help protect your portfolio from the risk of inflation.

  • The cost of inflation protection is an important factor when investing in TIPS, not just the current rate of inflation. Today that cost of protection is relatively low.

  • For longer-term investors, TIPS look relatively attractive compared to traditional Treasuries. But yields are low, so total return expectations should be tempered accordingly.

Looking for investments that can keep pace with inflation? Consider Treasury Inflation-Protected Securities, or TIPS.

Inflation can be a detriment to investors since it can eat away at investment returns. When building a diversified portfolio, positive total returns aren’t the only thing to consider—making sure your investments keep pace with inflation is important, as well.

TIPS can help investors protect against a rise in prices, because their values are indexed to the level of inflation. Today, TIPS look relatively attractive compared to traditional Treasury securities. But on an absolute basis, yields are still very low, and total return expectations should be tempered accordingly.

Below we’ll go over the basics of TIPS and some factors to consider before investing.

TIPS basics

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

TIPS also have some unique characteristics that differentiate them from traditional Treasuries. The principal value of a TIPS is indexed to inflation. So if inflation rises, so too does the value of a TIPS; if deflation were to occur and the overall level of prices were to fall, the value of a TIPS would fall also. The index used for TIPS is the Consumer Price Index for All Urban Consumers, or the CPI.

The coupon rates of TIPS are fixed, but the actual coupon payments can vary based on the level of that fluctuating principal value. For example, assume a 10-year TIPS is issued with a 1% coupon rate and a $1,000 par value. If there were no inflation that year (meaning the CPI was unchanged for the whole year), the principal value would still be $1,000 and the annual coupon payment would total $10 per bond.

Now let’s assume that inflation picked up in year two and the CPI rose 2% for the year. At the end of year two the principal value would now be $1,020 and the coupon payment would rise to $10.20 per bond. (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.

There are special considerations for those investors who purchase TIPS in the secondary market. If deflation hits after you’ve purchased a TIPS in the secondary market, it’s possible that principal value could be less than the principal value when purchased.

Three things to consider before investing in TIPS

Adding TIPS to a portfolio can help protect against the effects of inflation, but there are a few things to consider before diving in. The cost of the inflation protection matters, as does the outlook for inflation. Last, the yields that TIPS offer matters. Today, yields of all Treasury securities are low, so investors should manage their total return expectations accordingly. Here are three considerations for potential TIPS investors:

1. Breakeven inflation rates. The breakeven inflation rate is the difference between the yield of a traditional Treasury and a TIPS with a comparable maturity. For example, if the yield of a 10-year Treasury note is 2% and the yield of a 10-year TIPS is 0.25%, then the breakeven inflation rate is 1.75%. TIPS tend to offer lower yields than traditional Treasuries, as traditional Treasuries don’t offer the benefits of adjustments to principal when inflation rises.

The breakeven inflation rate is the rate at which inflation—as measured by the CPI—would need to average over the life of a TIPS for its total return to break even with the total return of that comparable Treasury security.

In the example used above, if inflation averaged more than 1.75% over the 10-year investment horizon, then the TIPS would generate a higher total return than the traditional Treasury note. Conversely, if inflation averaged less than 1.75% over that 10-year span, then the Treasury would outperform the TIPS.

So when investing in TIPS, the price at which you invest matters. Today, TIPS breakeven rates are relatively low. At 1.5% and 1.6%, respectively, five- and 10-year breakeven rates are below their since-inception averages and below the Fed’s 2% inflation target.1

Today’s entry point is relatively attractive for long-term investors looking for inflation protection. While allocating to TIPS should never be an “all or nothing” approach, investors should consider holding some TIPS at the expense of Treasuries today.

Breakeven inflation rates are relatively low

Source: Bloomberg, using weekly data as of 10/30/2019. TIPS 5 Year Breakeven Inflation Rate (USGGBE05 Index) and TIPS 10 Year Breakeven Inflation Rate (USGGBE10 Index). Past performance is no guarantee of future results.

 

2. Actual inflation. While the hurdle rate for relative outperformance may be low, actual inflation readings still remain somewhat tame. The headline CPI has dropped from a recent high of 2.9% down to 1.7% in September 2019, very close to current breakeven rates. Looking at additional inflation measures, like the core CPI, which excludes volatile food and energy prices, as well as both the headline and core personal consumption expenditures (PCE) readings, the rate of inflation has generally remained within the range of 1% to 3% for the past three years.

Unless the rate of inflation rises much more going forward, the potential outperformance of TIPS is likely somewhat limited. According to the Federal Reserve’s Summary of Economic Projections released in September, both headline and core PCE are expected to rise to just 1.9% and 2.0%, respectively, in 2020 and 2021.

Most inflation readings have been in a tight 1% to 3% range for the last three years

Source: Bloomberg, using monthly data as of September 2019 for the CPI, and as of August 2019 for the PCE. US CPI Urban Consumers YoY NSA (CPI YOY Index), US CPI Urban Consumers Less Food & Energy YoY NSA (CPI XYOY Index), US Personal Consumption Expenditures Chain Type Price Index YoY SA (PCE DEFY Index), and US Personal Consumption Expenditure Core Price Index YoY SA (PCE CYOY Index).

 

3. Manage your total return expectations due to low yields. The yield of a 10-year TIPS is just 0.18%, while the yield of a five-year TIPS is just 0.11%.2

When TIPS yields are positive, investors can earn positive inflation-adjusted total returns if held to maturity even if inflation rises sharply. The same can’t be said for traditional Treasury securities.

While the breakeven inflation rates are relatively attractive compared to history, TIPS absolute returns will likely be low given the low starting point with yields. This is an important caveat when considering TIPS: inflation protection doesn’t necessarily mean high total returns.

What to do now

TIPS are one of the most straightforward ways to protect a portfolio against the effects of inflation. On a relative basis, TIPS can make sense compared to traditional Treasuries today given the relatively low breakeven inflation rates. However, on an absolute basis, it’s important to keep your return expectations in check.

There are a few ways to invest in TIPS. Investors who prefer to invest in mutual funds or ETFs can browse potential funds on the Mutual Fund Select List or the ETF Select List. When browsing each list, first select “Taxable Bond” as the type of fund, then search for funds in the “Inflation-Protected Bond” category. Please note that many mutual funds in this category invest in many different types of bonds to outperform inflation—they don’t always invest exclusively in TIPS. ETFs, on the other hand, often offer more of a pure play on the TIPS market than mutual funds.

If you’re a Schwab client and you prefer owning individual bonds, you can log in and find TIPS on the client center on Schwab.com under the “Find Bonds & Fixed Income” page. Once there, select “Treasuries” as the bond type, and then below select “Include Only Treasury Inflation-Protected Securities (TIPS).”

 

1As of 10/30/2019

2As of 10/30/2019

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Important Disclosures:

Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

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.

The Personal Consumption Expenditures (PCE) index calculates the increase in average pricing for all domestic personal consumption. The "core" PCE price index is defined as personal consumption expenditures prices excluding food and energy prices.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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