HOW TIPS WORK

TIPS are currently issued in 5-, 10- and 30-year maturities. Like other U.S. Treasury securities, they have effectively no default risk, carry a fixed interest rate (coupon), and make fixed coupon payments every six months. Unlike conventional Treasury bonds, TIPS’ principal is adjusted based on the monthly rate of inflation.

Those principal adjustments affect the securities’ coupon payments as well as their payout at maturity, because payments are calculated as a percentage of adjusted principal. The table below demonstrates how changes in principal would affect the interest payments made by TIPS with a 2% coupon.

It’s important to note that the IRS considers increases in TIPS’ principal, due to monthly inflation, to be taxable income in the year they occur. Investors who hold TIPS directly should be aware of this phantom income and plan accordingly.

KNOW WHAT TO EXPECT FROM TIPS

The concept of adjusting principal to account for inflation is relatively straightforward. That said, the process by which TIPS account for inflation can cause the securities to perform differently than investors may expect. One common source of confusion: TIPS principal amount is adjusted based on the non-seasonally adjusted Consumer Price Index (CPI-NSA), not the seasonally adjusted CPI that media reports tend to focus on.

…the process by which TIPS account for inflation can cause the securities to perform differently than investors may expect.

Headline CPI smooths out the impact of seasonal factors that affect the prices of items such as food and energy. For example, the prices of different foodstuffs can vary with harvest cycles, while gasoline tends to be more expensive during the summer travel season. Monthly headline CPI numbers are adjusted to account for those kinds of seasonal variations; non-seasonally adjusted CPI is not.

That system means TIPS’ payments may not match the inflation numbers clients read in the news. For example, in December 2021, headline inflation increased at a monthly rate of 0.5%, while the non-seasonally adjusted index that determines TIPS adjustments rose just 0.3%.¹

TIPS ADJUSTMENTS HAVE A THREE-MONTH LAG

Another common source of confusion: The inflation that happens in a given month isn’t fully reflected in TIPS’ coupon payments until three months later. The process for adjusting TIPS’ principal proceeds as follows:

…there will always be a lag between when inflation occurs and when TIPS’ principal and coupon payments reflect it.

This process means there will always be a lag between when inflation occurs and when TIPS’ principal and coupon payments reflect it.

To give a recent example, some investors holding TIPS in an ETF or Mutual Fund were surprised to see only small increases in their coupon payments in March 2022, after inflation hit multi-decade highs in February. The explanation: The increase in TIPS’ March payments reflected the more-modest inflation three months earlier, from December 2021.

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.

Moreover, duration for TIPS is a moving target. A fixed-income asset’s duration is calculated based on its principal amount and expected cash flows. 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. The resulting fluctuations in TIPS duration make it difficult to measure a TIPS portfolio’s interest rate risk with any precision.

Modified Adjusted Duration (MAD) for TIPS is calculated using the Market’s estimate of future inflation to arrive at a duration calculations that allows the interest rate risk of TIPS to be comparable to other fixed income securities. This is critical as duration plays such an important role in determining expected fixed income returns.

EXPECTED INFLATION IS ALREADY PRICED IN

Like other Treasury securities, TIPS trade on the open market. To determine the yield they’ll accept for a given TIP security, investors take the yield of a conventional Treasury of equal maturity and subtract the expected inflation rate over that time period. For example:

Over time, if inflation matches the breakeven rate, TIPS offer no advantage over nominal (ie, non-inflation-adjusted) Treasuries with a similar duration.

The expected inflation built into TIPS’ yield—3.0% in the example above — is called the breakeven rate. Over time, if inflation matches the breakeven rate, TIPS offer no advantage over nominal (ie, non-inflation-adjusted) Treasuries with a similar duration. In this example, both would pay a real, after-inflation yield of -0.5%. This dynamic holds no matter how high or low inflation may be: If the market accurately anticipates the inflation rate, TIPS’ yield will account for it and investors would fare just as well in an ordinary Treasury bond with a like duration.

Put another way, TIPS don’t help protect against expected inflation. They perform better than comparable nominal Treasuries only when inflation exceeds the breakeven rate, causing their principal to increase more than investors had priced in. If inflation falls short of the breakeven rate, the investor is better off in nominal Treasuries.

KEY CONSIDERATIONS FOR TIPS INVESTORS

The TIPS market historically has been very good at pricing in near-term inflation. TIPS’ prices and yields typically start reflecting expectations for a given months’ inflation about six weeks before it’s reported,³ and reflect 98% of the inflation figure by the time it’s announced, on average.⁴

The upshot: By the time inflation is high, it’s already priced in to TIPS and too late to act on. That said, TIPS can be a valuable strategic hedge against the kind of unexpected inflation we have seen since mid-2021.

The TIPS market historically has been very good at pricing in near-term inflation.

That spike in prices has drawn attention to the need to protect portfolios from inflation’s impact on income and financial assets, especially fixed-income securities. TIPS can help protect against the risk that prices may continue to rise much faster than anticipated. But investors shouldn’t count on TIPS to protect against inflation that’s simply high, and they should be prepared for this distinctive asset’s idiosyn­crasies, such as its uncertain duration and the lag in reflecting monthly inflation.

A diversified portfolio that includes a range of inflation-hedging assets — including dividend growth stocks, natural resources and real estate as well as TIPS — can help clients provide the inflation protection they need while pursuing long-term investment objectives.

DEFINITIONS

Bloomberg 1-10 Year U.S. Government Inflation – Linked Bond Index is designed to measure the performance of the inflation protected public obligations of the U.S. Treasury commonly known as “TIPS” that have a remaining maturity greater than or equal to 1 year and less than 10 years.

FOOTNOTES

¹ U.S. Bureau of Labor Statistics, Consumer Price Index News Release, January 12, 2022.

² Real yield is the nominal market yield less inflation expectations for a given term.

³ Simons, Howard, 2011, “TIPS React Very Prematurely to Commodity Movements.” Arbor Research/Bianco Research Connections – Tying Markets Together, Vol. 8, No. 159.

⁴ Chu, Quentin C., Pittman, Deborah N., Yu, Linda Q., “When Do TIPS Prices Adjust to Inflation Information?” Financial Analysts Journal, Vol. 67, No. 2.