3 reasons investors should consider TIPS — even if inflation slows down

Highlights Sep.21,2022 17:22

Treasury Inflation-Protected Securities (TIPS) have historically helped investors hedge against inflation, provided diversification to traditional portfolios, and TIPS ETFs are tax efficient. In an inflationary environment, investing in TIPS may provide higher levels of income and better total returns vs. nominal Treasuries, which aren’t adjusted for inflation. TIPS are affected by changes in CPI inflation and changes to the market’s expectations for future inflation, helping to explain their performance since early 2021. Treasury Inflation-Protected Securities (TIPS) haven’t generated positive returns so far this year, despite inflation hitting the highest levels since the early 1980s.¹ Some investors may find this development confusing and wonder if adding inflation-protected bonds to their portfolios makes sense.

Whether inflation simmers down from here or surges again, we believe TIPS have an important role to play in portfolios for three key reasons: TIPS help investors hedge against inflation, provide diversification to traditional portfolios, and TIPS ETFs are tax efficient.

Here’s a refresher on how TIPS work and an explanation for their sluggish year-to-date performance.

WHAT ARE TIPS?

TIPS are government bonds with principal values that are adjusted based on changes in inflation. A bond’s principal, also known as its face or par value, is the amount of money the bond issuer agrees to pay investors when the bond matures.

Here’s how TIPS work, according to the U.S. Treasury Department:²

The TIPS’ principal increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI). When TIPS mature, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation. To recap, the income, or interest payment, provided by TIPS is directly impacted by changes to CPI. Seems straightforward, right?

However, the total return of a TIPS portfolio will be impacted by changes in interest rates and changes to the market’s expectations for future inflation. Total return refers to the actual return on an investment, including your original principal and interest payments, as well any gain or loss in the value of your original principal and (when applicable) capital gains, dividends, and distributions. Total return is calculated as a percentage of the amount invested.

HOW HAVE TIPS PERFORMED RECENTLY?

When inflation is rising, the income provided by TIPS (and ETFs that hold them) can be higher than traditional , or nominal, fixed-income portfolios, which aren’t adjusted for inflation.

TIPS ETFs can provide increased levels of income when inflation is high
Annual ETF distribution yields

Source: Bloomberg. The Average ETF Distribution Yield is the average monthly distribution as a % of NAV in each year, annualized; 2022 YTD performance as of 8/31/22. CPI YoY Change is the end of year US CPI Urban Consumers YoY NSA Index.

Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. This information must be preceded or accompanied by a prospectus. For standardized performance and most recent month-end performance, as well as a prospectus for these funds, click the following links:

Chart description: This chart shows a comparison of the income generated by inflation-protected securities (represented by the vs. nominal Treasuries).

After generating positive total returns for investors in 2021, TIPS have produced negative total returns year-to-date in 2022.³ Again, that’s despite CPI inflation posting its largest year-over-year increase since November 1981.⁴

Two developments may help explain this apparent contradiction:

First, interest rates jumped after the Federal Reserve started raising interest rates; yields on the 10-year U.S. Treasury note rose 92 basis points from March 31, 2022 to July 31, 2022.⁵ Higher rates caused bond prices — which move in the opposite direction of yields — to decline, including on TIPS securities. The additional rises in CPI inflation this year were not enough to offset the losses resulting from higher rates. Second, as noted above, the total return of TIPS is affected by inflation expectations, not just actual CPI prints. In 2021, demand for TIPS securities rose in conjunction with an increase in inflation expectations. From May 2021 to December 2021, 2-year breakeven rates — the difference between yields on TIPS and nominal Treasuries with the same duration, and the market’s expectation of future inflation — moved higher. As a result, TIPS outperformed traditional bonds last year as both actual and expected inflation rose while interest rates stayed flat. In other words, TIPS rose in price ahead of the actual published change in CPI.⁶ Additionally, TIPS have outperformed traditional Treasuries since the start of 2021 on a total return basis.

TIPS total returns: Driven by interest rates and inflation expectations
Breakdown of TIPS total returns by driver beginning in 2021

Source: Bloomberg as of 7/30/22. The TIPS Total Return is the return of The Bloomberg US Treasury Inflation-Linked Bond Index, the Nominal Treasury Return is the return of The Bloomberg US Treasury Index adjusted to be on equal duration of the Inflation-Linked Index, and the Benefit from Inflation Expectations is the difference between the two.

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual Fund performance. For actual fund performance, please visit.

Chart description: This chart shows the total return of TIPS vs. nominal Treasuries from Jan. 1, 2021 through July 30, 2022.

Fast forward to the present and 2-year breakeven inflation rates are at 3.25%, significantly lower than the most recent year-over-year CPI change of 8.5%.7 This suggests the market is expecting inflation to moderate in the coming year.

Still, we believe inflation is likely to remain well-above the Fed’s 2% target for some time; indeed, August CPI data was higher than expected, and up 8.3% on a year-over-year basis, despite a drop in energy prices.8 Exactly how high and for how long will depend on several factors that are difficult to predict. But if inflation does surprise higher, TIPS can offer a hedge against further inflation risk, while also providing current income.

The is the largest TIPS ETF, with $30.6 billion of assets as of June 30, 2022.⁹

For investors worried higher interest rates will continue to negatively impact total returns, the can provide a similar level of inflation protection with a lower duration profile.

WHERE DO TIPS FIT INTO A PORTFOLIO?

Most traditional broad fixed-income benchmarks, such as the Bloomberg US Aggregate Index, do not include TIPS. As a result, investors may not own any TIPS in their core bond allocations. TIPS ETFs offer a low-cost and efficient way to

TIPS also provide investors an opportunity to diversify against other major asset classes. The correlation of TIPS to the S&P 500 was just 0.3 in the past decade and 0.5 to high-yield corporate debt.10 Correlation is a measure of the relationship between assets, as represented by a value range of -1 to 1; the lower the number, the weaker the relationship.

TIPS deliver diversification to other traditional asset classes Correlation of TIPS to traditional asset classes

TIPS are represented by The Bloomberg US Treasury Inflation-Linked Bond Index and Nominal Treasuries are represented by The Bloomberg US Treasury Index, High Yield Corporates are the Bloomberg US High Yield Corporate Index, US Aggregate Index is the Bloomberg US Aggregate Bond Index, and S&P 500 is the S&P 500 Index. Past correlations not indicative of future correlations.

Another advantage of TIPS ETFs is particularly attractive for investments in taxable accounts: When the principal of TIPS is adjusted upwards by inflation, the IRS considers this income, even though it is not distributed to holders of individual TIPS securities (a concept referred to as “phantom income"). The will pay out this inflation adjustment as part of the monthly income so the cash flow the investor has the potential to exceed the tax liability.

CONCLUSION

Just as you might own to hedge against the possibility for declines in the equity market, investors should consider having at least some allocation to TIPS to hedge against the possibility of higher-than-expected inflation. In addition, TIPS have historically provided investors diversification and potential tax benefits, making them a core element to a well-rounded portfolio.