Analyst Insight
The current inflationary impulse due to pandemic related demand and supply chain disruptions has proven to be less transitory than initially envisioned. Since then, monetary authorities have pivoted and have shown an inclination to increase interest rates to temper inflation and inflation expectations. Given the stickiness of inflation, a large swathe of investors have also pivoted to brace themselves for more sustained price increases through altering the mix of assets in their portfolios. One of the most inquired about assets by individual investors in this regime has been Treasury Inflation-Protected Bonds or TIPs for short. In this piece, we will go through what are TIPs, a slightly technical dive into whether they present a good investment option currently, and lastly how to buy them.
What are TIPs?
TIPs are simply bonds issued by the US government that protect against inflation. They do this by having a principal amount that is indexed to inflation. That is the principal increases with inflation and decreases with deflation as measured by the Consumer Price Index. When the TIPs mature you then get paid the adjusted principal or the original principal, whichever one is greater. Of note, the interest paid on TIPs is determined at auction and as such is fixed at the onset. However, the actual interest that one receives from TIPs varies because the interest is paid semi-annually with the fixed interest rate being applied to the adjusted principal.
The table shows an example of a hypothetical TIP and how the interest payment and principal would be calculated (assuming 2-year tenor and yearly interest payments). From this, we see that assuming a yearly range of inflation of 2.5% the principal in year 2 grows to $1050.63 while the rate of interest (2.0%) is now applied to this increased principal ($21.01). When the security matures in year 2 the purchaser receives the $1050.63 in adjusted principal. It is important to note that in the unlikely case of deflation it is indeed possible to lose on the principal if you sell in the secondary market before maturity. If you however hold until maturity you are guaranteed to receive at least the original principal as stated prior
Are TIPS a good Investment now?
One thing to note is that purchasing tips doesn’t always mean you will be protected / it will be a good investment in an inflationary environment. There are nuances involving the timing of purchases and the characteristics of inflation and inflation expectations that determine whether TIPS presents a good investment option. For this, it is important to look at the breakeven inflation rate. This is essentially the difference between a treasury note and TIPs of similar tenors. This difference in yields is the inflation risk premium which is baked into treasury yields.
For example, the 5-year breakeven rate as of the date this article was written was 2.79%. This compares to the historical average over the 2010 to 2019 period of approximately 1.75%. This means that if you were to buy the 5-yr TIP at this point (which based on historical breakevens is relatively expensive) inflation would need to average over 2.79% over the next 5 years for the TIP to be a relatively better purchase than the 5-yr treasury. In addition to this, TIPs are exposed to interest rate risks just like the typical treasury. That is if interest rates increase then the price of TIPs will likely decline.
Based on these two factors, that is, given that inflation current breakevens are above historical levels and that there still exists the possibility of higher interest rates in 2022 the best times to buy TIPS would have been at the onset of the pandemic or right at the onset of the major uptick in inflation. While TIPS can have an outsized 2022 relative to treasuries, implicit in your decision to buy tips as opposed to treasuries now would be a bet on inflation on average, remaining above the FED’s 2% target over the intended tenor/holding period. In summary at current breakevens buying TIPS is a relatively expensive bet depending on the tenor. Despite this, in the scope of overall portfolio construction we do believe TIPs do add some amount of diversification and inflation protection for investors’ portfolios particularly over a longer-term time horizon.
How to purchase
In terms of getting access to TIPs, larger investors can buy them directly from one of the 4 yearly auction dates (January, April, July, and October) as well as by varying maturities from the secondary market through broker platforms such as Fidelity and Interactive Brokers. One can also have access to smaller denominations through buying into mutual funds such as Fidelity Inflation-Protected Bond Index Fund (10.9% total return in 2020 and 5.93% in 2021) or T Rowe Price Protected Bond Fund (11.06% total return in 2020 and 5.31% in 2021). Lastly and perhaps the easiest for the average investor, one can purchase Exchange traded Funds (ETFs) which invest directly into TIPs such as the SPDR Portfolio TIPS ETF (SPIP) which had a return of 5.8% in 2021.
In conclusion: TIPS are treasury securities with in-built inflation protection. While they represents decent long term hedges against inflation we believe currently as a shorter-term play against inflation breakevens suggest they are relatively expensive compared to regular treasuries based on historical levels.
Written by Peter-George Simon
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