Investors flocking to Treasury inflation-protected securities may be in for a rude awakening when interest rates start to rise.
TIPS, introduced in the late 1990s to help the most conservative investors keep pace with inflation, have gained in popularity over the past few years as rising government debt levels and record spending stoke fears of inflation.
Simple logic — supported by history — suggests that the federal government will resort to inflation in order to wiggle out of its mountainous debt load.
For that reason, TIPS seem attractive. With “inflation protection” embedded in the name, one could forgive investors for assuming that TIPS represent a safe haven from the ravages of inflation.
When compared with traditional Treasuries, TIPS do provide an advantage in certain inflationary periods. But it would be a mistake to consider TIPS the best way to hedge the inflation risk of an entire investment portfolio.
“Under normal circumstances and over long periods of time, stocks will be the best inflation hedge,” said Eric Jacobson, an analyst with Morningstar Inc. “TIPS fit for people who don't feel like they can take on the risks of equities.”
Unlike nominal Treasury bonds in which the principal value is fixed, the principal value of TIPS is designed to adjust in stride with inflation as measured by the consumer price index.
This means that if the CPI climbs by 4%, the principal value of the TIPS bond will increase by 4%. The rub, however, is that a TIPS bond is essentially a low-yielding Treasury bond, and from that perspective the yield and price of the bond is highly correlated to regular Treasury bonds.
Thus, yields on TIPS over the past few years have fallen along with the rest of the fixed-income universe, and that — along with strong demand — has driven up prices. A 10-year TIPS bond yields about 1%, which compares with a 3.4% yield on a comparable 10-year Treasury.
The 2.4% spread between the two is the market's expectation for inflation over the life of the bonds. If inflation climbs by more than 2.4%, an investor would have been better off with the TIPS bond.
“The best way to look at a TIPS investment is to consider the break-even inflation rate,” said Jeremy Fletcher, a portfolio manager at Asset Dedication LLC.
However, “there is no such thing as a really good predictor of inflation, including the spread between TIPS and Treasuries,” he said.
There also is another factor that could trip up investors.
Interest rates and inflation often move in tandem, but not always. So if interest rates start to climb in the absence of inflation, TIPS investors will suffer the same fate of all other fixed-income investors: the price of their bonds will plummet.
It is possible that the increased principal from inflation could offset the declining price of the TIPS bond, but that might be a small consolation.
The best possible scenario for TIPS would be stagflation, during which inflation is high but the overall economy isn't strong enough to support higher interest rates.
“You need high confidence in a very narrow scenario to believe that TIPS will be the superior asset class,” said Robert Tipp, chief investment strategist of fixed income at Prudential Financial Inc.
Ultimately, it comes down to the risk of mistaking TIPS for an automatic inflation hedge, when in fact they are best suited as a hedge against nominal Treasury bonds.
Although there hasn't been any significant inflation in the United States since TIPS were first introduced in 1997, back-tested research by Invesco Ltd. suggests that even cash and short-term Treasuries would outperform TIPS during periods of high inflation.
“So far, inflation hasn't risen to the degree where investors have needed the protection, but [the protection] is less certain than most investors assume,” said Scott Wolle, chief investment officer of the global asset allocation group at Invesco.
“There's a fairly widely held belief that TIPS will hedge inflation, but that depends on whether there is enough protection to offset the other losses, and that depends on how much you have allocated to TIPS,” he said. “I don't think most investors have thought that all the way through.”
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
