Hedging inflation requires tiptoeing through TIPS

Treasury inflation-protected securities have become the hottest ticket in 2021 as messages about 'transitory' inflation clash with reality.

As the Biden administration continues its efforts to tamp down growing concerns about inflation with messages of “transitory” and “temporary,” the markets and consumers are living in the reality of higher prices.

For financial advisers, this means placing inflation management at the top of their to-do lists, and for a lot of advisers the go-to move has been toward Treasury inflation-protected securities, also known as TIPS.

According to CFRA, $34 billion has flowed into TIPS exchange-traded funds so far this year, pushing the total asset base up to $96 billion.

A report from Morningstar shows that TIPS have been leading fixed income returns all year, with the Morningstar US TIPS Index up 4.95% through October, including an impressive 1.76% gain in October.

Beyond just good performance in the current fixed-income market, where yields are barely keeping up with inflation, the TIPS story illustrates the lack of confidence in the message coming out of Washington regarding the threat.

As Morningstar’s Lauren Solberg explains, TIPS offer a perspective on inflation expectations through the so-called breakeven rate that compares yields on TIPS with their non-inflation-adjusted counterparts.

Think of the breakeven rate for TIPS as the expected rate of inflation for the period covered by the bonds.

“Currently, the difference between 10-year TIPS and nominal Treasury yields is 2.67%, up from 2% at the start of 2021 and a level last seen in April 2006,” Solberg writes in her report. “In fact, the last time that the 10-year breakeven rate rose above 2.5% was during the summer of 2013.”

Seems straightforward enough, but as any market watcher will attest, these are unprecedented times and jumping headlong into TIPS might not be the most prudent strategy for everyone.

“There’s been a huge investor sentiment shift toward TIPS, which tells me people are worried about inflation, and TIPS are designed to be the tool for inflation when it’s anticipated,” said JR Rieger, owner of the Rieger Report of bond market commentary.

But viewing the Federal Reserve’s monetary policy as “manipulated” and acknowledging the unique confluence of events, including supply disruptions, worker shortages, and the uncertainty of the pandemic, Rieger said any new allocations to TIPS should be limited to the shorter-term variety.

“Stay with shorter-terms TIPS until we get a clearer inflation picture,” he said. “Stay within five years for this period of lack of clarity.”

Peter Yi, head of short duration fixed income at Northern Trust Asset Management, recognizes the appeal of TIPS, especially with five-year TIPS offering a breakeven rate close to 3%, but he believes financial advisers should consider whether the current level of inflation can be sustained much beyond next year.

“We’re still in the transitory inflation camp, more than structural inflation camp,” he said. “I don’t think anyone is questioning that prices are higher today, but will they be higher on a relative basis next year? And our view is, no they won’t be.”

While Yi believes the Federal Reserve is still a couple of years away from raising interest rates, he expects the supply chain disruptions and worker shortages that are in part driving inflation to be ironed out in relatively short order.

“Investors are realizing the absolute inflation rate today is pretty high, but in order for it to be sustainable, inflation has to increase another 4% or 5% next year,” he said.

Put that way, TIPS start to look less appealing as a longer-term allocation. That’s also why Yi is among those favoring allocations to natural resources, infrastructure, and global real estate as a hedge.

“Bottom line is, inflation is a big debate,” he added.