INTEREST RATES ARE CRITICAL TO TIPS RETURNS
TIPS investors often focus on inflation’s impact on their income and total returns. They should bear in mind that changes in the level of interest rates also have major impact on performance, as they do with other fixed-income securities.
When interest rates rise, the value of fixed-income securities falls; when rates fall, fixed-income values rise.
When interest rates rise, the value of fixed-income securities falls; when rates fall, fixed-income values rise. A given security’s sensitivity to interest rate moves is measured by duration, the weighted average time until it repays the bondholders’ initial investment. The longer a fixed-income investment’s duration, the more its price will fall with each increase in rates.
TIPS’ principal changes virtually every month due to realized inflation and future cash flow estimates are impacted by future inflation expectations, therefore TIPS duration changes constantly.
Rising real2 interest rates have the potential to overwhelm inflation’s effect on TIPS’ returns, especially for securities with long durations. The chart below illustrates how much of TIPS’ returns between 2003 and 2021 could be explained by inflation versus duration (that is, changes in real interest rates). For TIPS with durations of 10 years or longer, interest-rate moves affected returns almost six times as much as inflation did.