Defined Benefit
Defined Contribution
Insurance Assets
Nonprofit
Registered Investment Advisers

Tips on TIPS

Tips on TIPS
clock
4 min 9 sec

With inflation concerns on the minds of many investors, asset classes and securities that can help mitigate its impacts have gained new interest. Among these securities are TIPS, or Treasury Inflation-Protected Securities, because they are designed to provide protection against unexpected inflation.

The market’s expectation for future inflation, as measured by the CPI, is reflected in the price of TIPS. TIPS are issued with lower yields than nominal Treasuries because investors are compensated for inflation over the life of the security.

Here is how they work: TIPS pay interest every six months based on a fixed rate applied to the principal outstanding. The inflation protection comes from changes made to the principal value of the bond, which is adjusted for inflation as measured by the Consumer Price Index-All Urban Consumers (not seasonally adjusted).

At maturity, the greater of the adjusted principal value or the issuance value (par) will be paid. The amount paid out at maturity will reflect inflation as measured by the CPI. The principal value cannot be adjusted below par, and thus this feature benefits investors in a deflationary environment (when CPI changes are negative) if and when this “floor” (par value) is reached. This feature introduces a bit of “optionality” into TIPS because the potential for price changes is asymmetric—the principal can be adjusted upward without limit but cannot be adjusted below par value if CPI declines.

Here’s an example of how TIPS work:

  1. April 15, 2014: 5-year TIPS issued at par ($1,000) with a coupon rate of 0.125%. CPI was 234.31967.
  2. October 15, 2014: First coupon payment due and CPI was 238.07026 (change of 1.6%). Coupon payment will be 0.125% x $1,000 x 1.016% / 2.
  3. April 15, 2019: CPI was 252.20853; change of 7.6%. Principal repaid will be $1,000 x 1.076%.
  4. If deflation had occurred over that period (i.e., the CPI had fallen), principal repaid would be $1,000.

The performance of TIPS is driven primarily by changes in inflation expectations and changes in real yields. Further, TIPS can be less liquid than nominal U.S. Treasuries at times, especially during periods of market stress, and short-term price changes may reflect some “liquidity risk.” TIPS are backed by the full faith and credit of the U.S. government, like nominal U.S. Treasuries, and thus do not have credit risk.

Another important concept to understand about TIPS is that of “breakeven spreads,” which are the differences in yields between nominal Treasuries and TIPS of the same maturity. This spread is a measure of expected inflation (i.e., the inflation that is priced into the market) over the life of the bond.

Example: 

  • March 31, 2021: 5-year TIPS yield = -1.62% vs. 5-year U.S. Treasury yield = 0.92%
  • Difference = 2.54%
  • Investors expect inflation over the next five years to be 2.54%.
  • If it is higher, TIPS will outperform over the five-year period.

Active core and core plus fixed income managers include TIPS in their opportunity set, although they are not in the Bloomberg Barclays US Aggregate Bond Index. TIPS are viewed as relative value opportunities when a manager expects inflation to be higher than what is reflected in TIPS valuations.

Institutional investors can include TIPS in their portfolios either as part of a dedicated strategic allocation, or as a tactical allocation. For both, the source of funds is important to consider from a relative value perspective as well as from the impact on overall fixed income structure characteristics such as duration, yield, and credit quality.

Here are some considerations:

Strategic allocation

  • TIPS provide protection against inflation as measured by the CPI if held to maturity; however, interim price changes will reflect changes in real interest rates and changes in expected inflation and can be volatile.
  • Shorter-term TIPS have demonstrated a higher correlation to CPI than longer-term TIPS, due primarily to the fact that they have less interest rate sensitivity, which tempers price movements due to changes in real rates. Prices of longer-term TIPS fluctuate more due to interest rate sensitivity than to changes in CPI.
Shorter-term TIPS Are More Correlated to Inflation than Longer-term TIPS
  • TIPS can be expected to outperform nominal U.S. Treasuries when actual inflation is higher than expected inflation.
  • They provide diversification benefits to equity exposure, but less so than nominal U.S. Treasuries, which are the investment of choice for investors seeking safety given the size and liquidity of the market, though both are backed by the U.S. government. The TIPS market is only a fraction of the size of the nominal U.S. Treasury market and there are fewer than 50 securities outstanding.

Tactical allocation

  • TIPS may make sense if an investor’s expectation for inflation is higher than what the market expects and the source of funds is fixed income.
  • They may be appropriate if the expectation is for real yields to fall.
  • A tactical implementation requires decisions around when to reverse the trade.

In summary, TIPS performance reflects changes in real rates as well as changes in inflation expectations; these are the key drivers of performance. Since TIPS will not return less than par at maturity, they also provide downside protection in a highly deflationary environment. Shorter-term TIPS provide a more pure hedge against unexpected inflation because they have less interest rate risk, but the hedge is imperfect.

Posted by

Share
Share on facebook
Share on twitter
Share on linkedin
Related Posts
Public Markets

Stellar Markets Across Asset Classes

Kyle Fekete
Callan expert assesses the global markets in 3Q24 and the outlook heading into the election.
Macro Trends

Election Tension but No Sign of That in the Markets

Kyle Fekete
Callan expert explains the major trends shaping the global economy as the U.S. election approaches.
Private Markets

Gains Outpace Leveraged Loans Over Time; Spreads Contract

Constantine Braswell
Callan experts analyzes private credit activity in 2Q24.
Macro Trends

Can the Fed Stick the Landing?

Jay Kloepfer
Callan expert analyzes the 2Q24 global economy and Federal Reserve policy.
Public Markets

Gains for Stocks Mask Wide Disparities; Little to No Change for Bonds

Kristin Bradbury
Callan expert analyzes the global stock and bond markets in 2Q24.
Macro Trends

Politics Upstage Economic News

Kristin Bradbury
Callan expert analyzes global economic issues in 2Q24 and the implications of political upheaval.
Private Markets

Private Credit Gained in 4Q23 but Lagged High Yield Benchmark

Constantine Braswell
Callan expert analyzes private credit activity in 1Q24.
Macro Trends

Investors, Be Careful for What You Wish

Jay Kloepfer
Callan expert analyzes the 1Q24 global economy and Federal Reserve policy.
Macro Trends

Are We Headed for an Economic ‘Rapid Unplanned Disassembly’?

Alex Browning
Callan analyst examines the state of the U.S. economy and the prospects for a soft landing.
Public Markets

Stocks Continue Rally; Bond Returns Fall Amid Rate Cut Uncertainty

Kristin Bradbury
Callan expert analyzes the performance of global markets in 1Q24 and the outlook for the year.

Callan Family Office

You are now leaving Callan LLC’s website and going to Callan Family Office’s website. Callan Family Office is not affiliated with Callan LLC.  Callan LLC has licensed the Callan® trademark to Callan Family Office for use in providing investment advisory services to ultra-high net worth clients, family foundations, and endowments. Callan Family Office and Callan LLC are independent, unaffiliated investment advisory firms separately registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940.

Callan LLC is not responsible for the services and content on Callan Family Office’s website. Inclusion of this link does not constitute or imply an endorsement, sponsorship, or recommendation by Callan LLC of their website, or its contents, and Callan LLC is not responsible or liable for your use of it. When visiting their website, you are subject to Callan Family Office’s terms of use and privacy policies.