TIPS, or Treasury Inflation-Protected Securities, have had a strong run over the past few years. But going forward, we see the risk/reward case for investing in TIPS as murky, and we see some alternatives like preferred stock ETFs and high yield corporate bonds as potentially better investments.
In this piece we’ll talk a bit about what TIPS are, why they’ve done so well, and why a risk-reward analysis makes the case for seeking out some alternatives to TIPS going forward.
What are TIPS?
TIPS are first and foremost U.S. Treasury bonds. This makes them a very safe investment, as they are supported by the U.S. government and its implicit “never fail” backing. But fixed-income investors seek more than just safety with their bond purchases – they also want at least a modest income (coupon) payment, and the potential for some pricing upside.
As the name suggests, TIPS are designed to offer protection against the rising prices that inflation brings. The principle amount (face amount) of a TIPS bond is indexed to the Consumer Price Index, so that when the CPI rises, the principle amount of a TIPS bond rises by the same amount. The coupon interest rate on a TIPS bond will be lower than a vanilla Treasury bond with the same maturity. But if inflation occurs (via a rising CPI), then that lower coupon payment will be paid on a larger face amount as the principle value of the bond rises in lockstep with the CPI.
TIPS are issued with maturities of 5, 10, and 30 years. The first TIPS were issued by the U.S government in 1997, and have been very popular with investors ever since. At maturity, a TIPS bond pays out either the original face amount of the bond at issuance, or the updated principle after adjusting for inflation, whichever amount is higher.
Why TIPS Have Performed So Well
It sounds paradoxical, but TIPS have performed well in recent years not because inflation has been high but because it’s been low! In this sense, TIPS have done well for the same reason all treasury bonds have done well. Interest rates have remained low and trended lower for several years, which is bullish for bonds, including TIPS. Though we should note, while TIPS have performed well, they haven’t done any better than a vanilla bond fund like AGG.
Consider the curious case of why in the past 2 months, when actual, real-time inflation is rising much faster than the market expected, TIPS are flat or falling. This is a reflection of how expectations of something in the future can be priced into a security early on.
The TIPS Spread and Inflation Expectations
The spread between the yields on TIPS bonds and regular Treasuries with the same maturity is a highly watched metric, as it shows how much inflation the market is expecting over the remaining years until both bonds mature.
The issue we have with inflation expectations via this chart – which has inflation topping out at 2.5% then retreating – is this: If real-time inflation is running at over 4%, who’s wrong – the market or the actual data? If the market’s expectation (of inflation running no hotter than 2.5% in future years) is too low, then TIPS could sell off rather dramatically in the near-term. This would create more volatility than we want for our clients. Meanwhile if the data ends up being wrong, if the market is right about “transitory inflation,” then TIPS will stay about the same, while paying below-market yields to holders. It will take a long-lasting surge in inflation above 4-5% for TIPS to offer meaningful upside from here.
History also gives us some valuable clues about how TIPS react when prevailing rates are already low, and the market suddenly becomes concerned about the Fed removing accommodation/stimulus measures. The so-called “taper tantrum” in the summer of 2013 happened when the Fed discussed tapering away from the quantitative easing that was put in place to help us out of the Great Recession of 2008-09.
What ensued was the worst 3-month performance bout for TIPS ETFs in the last decade. Many of the same variables could be in place now, further souring our near-term outlook for TIPS.
Alternatives For Inflation Protection
One rather obvious way to combat higher inflation is to seek out higher yields. We must consider the extra credit risk involved when “reaching up for yield”, but one area we like is high-quality corporate bonds that mature in the next 5-10 years. The iShares 5-10 Year Investment Grade Corporate Bond ETF (IGIB) meets this criteria well, and has an ultra-low expense ratio of just 0.06%.
While one could argue for moving even shorter down the curve, we think the 5-10 year range is appropriate given that we don’t expect extreme inflation to be long-lasting. Investment grade corporate bonds have an extremely strong risk profile – though yes, they’re still riskier than treasuries. Corporate balance sheets are in the best shape they’ve been in for many years and the economy is forecast to leap over 6% higher in 2021.
Another ETF we think can do well in a higher inflation regime is HYEM. HYEM is a high yield emerging market bond ETF that has a duration of less than 4. This means it’s not super sensitive to changes in interest rates but it boasts a yield of almost 5%. And lastly, we would expect gold, which hasn’t performed well so far in 2021, to fare much better in the future if inflation does prove to be persistent.
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