By: Jim Picerno
Director of Analytics, The Milwaukee Company
Inflation is a perennial enemy for bonds. To be precise, bonds that pay a fixed interest rate and don’t adjust coupon payments are vulnerable to a general rise in prices over time as inflation eats away at the purchasing power of the payouts. Most bonds are susceptible to this risk. Fortunately, the launch of inflation-indexed Treasuries more than two decades ago solved (at least partially) one of fixed-income’s main threats.
When you buy and hold a Treasury Inflation Protected Securities (TIPS), the security neutralizes inflation risk while providing a virtually nil level of credit risk, courtesy of the U.S. government. That leaves interest-rate risk – the risk that current yields will rise or fall, perhaps in unexpected ways – as the main threat for TIPS, and Treasuries generally. But hedging two of the three primary risk factors for the bond market is no mean feat. It adds up to a powerful platform for customizing the design and management of fixed-income portfolios.
One way to think through what TIPS bring to the strategic investing table: compare and contrast the securities against conventional Treasuries. In terms of yield, the two are mirror images of each other, offering complimentary payout structures.
Consider a standard 10-year Treasury Note, for example. Let’s say the current yield is 1.3%. If you buy and hold such a Note until maturity, you’ll earn a 1.3% yield over the life of the security. In other words, the investment locks in a 1.3% nominal yield -- the yield before adjusting for inflation. By contrast, the real (inflation-adjusted) yield on this 10-year Note will fluctuate, perhaps dramatically, depending on the path of inflation over the ten-year holding period.
A 10-year TIPS offers the exact opposite mix: a fixed real yield with a fluctuating nominal yield. That’s because the principal value of TIPS rises as inflation rises while the interest payment varies with the adjusted principal value of the bond. When you invest in TIPS, you’re locking in the current real yield. Regardless of how inflation changes over the holding period, your real yield is set in stone. On the other hand, the nominal yield for TIPS will ebb and flow in line with shifts in inflation and other factors.
In theory, if you bought a standard 10-year Note and its TIPS equivalent you’d be perfectly hedged. Of course, that implies a zero return. That leads to a key question: How to allocate a Treasury portfolio?
The ability to tap into a constant real yield/fluctuating nominal yield vs. the opposite suggests we need a forecast, or at least some basic assumptions about the ex ante trends for the main risk factors: inflation and interest rates.
If you expect inflation to accelerate, for example, locking in a real yield via TIPS is an obvious choice. Note that by locking in a constant real yield you’ll earn a fluctuating nominal yield, which will likely rise if inflation picks up.
On the flip side, if you think inflation will decline, a standard Treasury security is probably a better choice. Recall that when you own a conventional Treasury, the real yield varies while the nominal is fixed at the time or purchase. That’s a compelling profile if disinflation (or deflation) is on the horizon. In that environment, your realized real yield will rise because the constant yield payout will become worth more through time due to softer inflation.
In theory, the investment outlook is equivalent for a nominal and inflation-indexed Treasuries if inflation is steady from the time of purchase onward. In practice, this is a heroic assumption since inflation is rarely steady, particularly over longer periods. Meanwhile, standard and nominal Treasuries for a given maturity are usually priced differently. As such, market conditions can provide guidance for your expectations.
As a real world example, the current yield on a standard 10-year Treasury is 1.30% (as of July 23). The implied real yield (based on the 5.4% one-year increase in the Consumer Price Index (CPI) through June) is negative 4.1%.
By comparison, the current real yield on a 10-year TIPS on July 23 was a substantially-less-negative 1.05%.
For additional context, the Treasury market’s implied inflation forecast for the 10-year horizon (July 23) is 2.35% (based on nominal less inflation-indexed yields).
Considering these numbers suggests the Treasury market is either underpricing future inflation or CPI is due to decline substantially. Your outlook on this point should influence your thinking on whether to favor TIPS or standard Treasuries.
Keep in mind that there’s no law that says you have to choose one or the other security. Assume that you think inflation is set to rise further and so CPI’s current 5.4% pace will pick up to 6% or more. In that scenario, the TIPS investment will probably outperform a standard Treasury. But you’re only moderately sure of the forecast, estimating a 75% probability that inflation will rise. On that basis, there’s a case for holding a Treasury portfolio that’s 75% weighted in TIPS with 25% in conventional Treasuries.
Some investors might complain that buying TIPS with a negative real yield (even if it compares favorably to a conventional Treasury) is distinctly unattractive, especially on a buy-and-hold basis, which ensures a negative return (assuming that current yield is a rough proxy for expected performance, which it is for Treasuries).
Good point, but there’s a potential twist to consider: If inflation picks up and real yields go deeper into the red, the TIPS investment will probably generate capital gains as the market pushes up the bond’s price as CPI increases. In that case, a TIPS investment could generate profits ahead of the maturity date. But you would have to sell the TIPS investment before it matures to book the profit.
Nothing wrong with earning a profit, but now you’re left with receiving principal ahead of schedule, which introduces reinvestment risk. That puts you back to square one.
The good news: the Treasury market’s forever changing, offering a shifting mix of risk and reward, at varying prices. Reassessing the investment outlook for Treasuries may offer a better risk-reward outlook than when you previously evaluated the market. But the opposite may be true, depending on the date of reinvestment.
Timing, in short, can be a major source of risk and return, sometimes in excess of the usual suspects.