With inflation remaining stubbornly high, investors are looking at Treasury Inflation-Protected Securities, or TIPS, once again. Does buying TIPS make sense for your client's portfolio? The answer will depend on the investor's views on inflation, risk tolerance, time horizon and current bond allocation, among other variables.
When you purchase TIPS, you are making a bet or hedging against unexpected inflation because bond TIPS and regular bonds are priced with current inflation expectations baked in. When an investor buys TIPS, the par value will price daily based on the current inflation rate. TIPS are priced based on current inflation expectations, which is why they are lower yielding than Treasuries (more on that later).
Last year, even as inflation was present, TIPS were dismissed by many investors because they had a negative real yield — for instance, purchasing a $1,000 bond with the expectation of getting $975 back. As interest rates on bonds have risen, the same has occurred in the TIPS space. Currently, you can lock in a positive yield, making the TIPS market attractive investors once again.
TIPS as inflation forecaster
TIPS often make the most sense to investors that have a view (or fear) that inflation will remain stubbornly high over the next (however many) years — or to those whose crystal ball is telling them that their view on inflation is more accurate than that of the bond market.
Recent data from the U.S. Treasury Department can help explain what TIPS and the market are currently forecasting. On Oct. 17, a 2-year TIPS was yielding around 1.92%. For a 5-year TIPS, an investor could lock in a 1.72% rate. At 10 years, the rate was 1.51%. Compare these rates to a Treasury with the same maturity. In October, a 2-year Treasury was yielding 4.42%. By comparing the TIPS rate to the Treasury rate of equal maturity, investors are able to calculate the breakeven inflation rate.
Or, put another way, since there are thousands of traders all buying and selling based on their own forecasts, the breakeven rate can really be looked at as the current inflation forecast for that time period.
For instance, if an investor buys a 5-year TIPS at the Oct. 17 rate and inflation averages 2% over the full five years, the TIPS return would be 3.72% (1.72% at purchase + 2% inflation adjustments). In this scenario, the investor would have been better off purchasing a Treasury bond at 4.18%. If, however, inflation averages 3% over the next five years, then the investor's return would be 4.72%, which is greater than the 4.18% Treasury.
TIPS as hedge
TIPS could also make sense for an investor who wants to take a little lower potential return now in order to hedge against that inflation being much higher than anticipated. Many investors tend to view TIPS as a great hedge for the longer term. The thinking goes that if you are truly worried about inflation, a 2-year TIPS isn't going to really provide much protection given its short time horizon. A 10-year TIPS would make more sense to address such worries, and an argument could also be made for a 5-year TIPS as well. Adding an inflation hedge component could be a great complement to an already well-established bond ladder, especially now for those
TIPS risks
TIPS are not magic and they come with risks, most notably interest rate risk. As with bonds, if someone purchases a TIPS and then interest rates rise, the TIPS will lose value. A TIPS purchased last year would be down just like other bonds, but because we are in a historically higher inflation environment, it would be down less than most other bonds due to the inflation adjustments or repricing.
Another consideration is that because of this repricing there can be taxes triggered each year, even if the investor doesn't sell any of the holding. The IRS considers an increase in the value of the TIPS to be income. This is known as "phantom income" and can impact an investor's taxes. All else equal, TIPS are better placed in a qualified account vs. a taxable account, but tax impact should not be the sole decision-driver here.
