Inflation-Protected Bonds: understanding the risks and rewards

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It’s been more than 15 years since the federal government introduced U.S. inflation-linked bonds (called Treasury Inflation-Protected Securities, or TIPS). Given the unique way TIPS returns are calculated and the factors that influence performance, analyzing these fixed-income investments can be challenging for any investor, especially in the current environment, which is characterized by unprecedented Federal Reserve intervention, low inflation and rock-bottom interest rates. As the U.S. economy improves and positive momentum builds, however, investors should understand how these changing dynamics might influence TIPS performance going forward.

Article Highlights

  • Treasury Inflation Protected Securities (TIPS) have outperformed the broader fixed income market in recent years, despite low inflation.
  • Understanding the three main components of TIPS returns: interest rates, inflation adjustment and price change is key before making an allocation.
  • As the U.S. economy improves investors should understand how these changing dynamics might influence TIPS performance going forward.

TIPS performance has stood out in recent years, having outperformed the broad fixed income market on an annualized basis over the last decade1, (6.65% versus 5.18%) through December 2012, though inflation has remained low over that same period. Another aspect of the current TIPS market has been low real yields. Real yields are what investors get after factoring in inflation, and the real yields of TIPS have declined since the financial crisis of 2008/2009, an indication that investors have sought safe havens such as debt backed by the U.S. government.

So what is driving TIPS returns if it isn’t inflation? To understand why TIPS have outperformed the broader fixed income market in recent years, it’s helpful to understand the components of their total returns, which are as follows:

  • Real coupon (interest rate)
  • Inflation adjustment
  • Price change

Real coupon: As with nominal bonds, TIPS investors receive a regular semiannual dividend. Unlike nominal bonds, however, TIPS dividends are divided into two components: a real coupon (interest rate) and an inflation component. The real coupon is set at the initial auction of these bonds by the Treasury and reflects what investors believe will be the underlying real interest rate during the life of the inflation-linked bond—stripped of inflation. TIPS real coupon rates have been very low in recent years, indicating that investors have become so risk-averse that they are willing to hold bonds with historically low yields in exchange for principal safety. This reflects efforts by the Fed to keep short-term nominal rates as low as possible, as well as investor demand for longer-term government debt, which is pushing down longer-term Treasury yields.

Inflation adjustment: Both the yields and the principal of inflation-linked bonds are directly tied to inflation through the U.S. Consumer Price Index (CPI) for urban areas. TIPS provide a return that reflects changes in the CPI with a two-month lag. So an increase in consumer prices in any year means that investors with a direct investment in TIPS will see a similar increase in their dividend payout from the U.S. Treasury and a commensurate increase in the value of their invested principal. Over the past decade, inflation has been relatively low, coming in below the long-term average of 3% per year.

Price change: Price change is the third major component of total return for the TIPS index. In recent years, price change—even more than inflation—has been the source of the total return experience of TIPS. In contrast to the inflation return, which is set by changes in the CPI, and the coupon return, which is fixed at the initial TIPS auction, prices are affected by demand on the open market, where investors can buy and sell these securities on a daily basis. Price return has been affected recently by investors’ views or expectations regarding the prospects for inflation and deflation. In 2008, as markets and the economy both fell dramatically and painfully, many investors believed that consumer prices would begin to fall, even more than they eventually did. As a result, some investors sold inflation-linked bonds in favor of nominal U.S. Treasuries, driving down the price of TIPS.

Why an improving economy may hurt inflation-linked bonds
Investors should be aware that improving economic conditions could have an adverse effect on TIPS total returns. The Fed has indicated that it will wind down and ease off its stimulus programs as the economy improves, though slowly and it has previously telegraphed such changes well in advance of any action. There are signs over the last several months that the economy is improving, including steady employment growth, housing market stability and growing consumer demand and spending. These factors and others are contributing to a view that the U.S. economy is poised to grow more robustly this year and in 2014 compared to the low growth environment experienced since the recession ended in June 2009. There are other contributing factors to the current optimistic outlook, such as further stability in Europe and reaccelerating growth in China’s economy. These are good developments for investors and could entice them to move away from safe havens such as U.S. government bonds into riskier assets such as stocks and high-yield debt, should the news remain positive. The effect, however, could be less demand for nominal Treasuries, causing real interest rates to rise.

As recent TIPS returns have been attributable to a historic period of declining real interest rates, and heavy demand for safe haven asset classes, the opposite may occur as the economy and the broad financial picture improves. Like any fixed income investment, TIPS values fluctuate with rising and falling interest rates. TIPS, however, have been more sensitive than nominal Treasuries and the broader fixed income market to fluctuating rates, as TIPS portfolios are often characterized by long duration. The longer duration of TIPS strategies helped the asset class outperform in a declining real rate environment, but that same attribute could cause underperformance versus nominal bonds in a rising real rate environment.

To summarize the risk to investors: real yields are currently at all-time low levels with inflation expectations fairly benign. Real interest rates are largely driven by expectations for real growth in the U.S. economy and expectations for monetary policy by the Federal Reserve. Policy rates have been held near zero for over four years while the Fed has implemented several programs designed to stimulate economic growth. The Fed has made it clear that it will continue to maintain a low interest rate policy for this year and possibly next, though market forces and rapid economic improvement could drive real rates higher before the central bank takes action and changes its policies. Higher real interest rates could cause negative TIPS returns if price declines surpass the benefits gained from inflation accruals. In other words, if real rates increase and inflation remains low, investors could experience losses in the TIPS component of their portfolios.

A good source of diversification
TIPS provide benefits for all investors and should be considered a core component of any well-diversified bond portfolio. They are backed by the full faith and credit of the U.S. government, which provides stability and security in addition to offering a unique inflation-protection component, which can help investors protect the long-term value of their assets against the corrosive effects of inflation. TIPS’s unique behavior relative to other bonds makes them an important asset class for those in or near retirement to hold as part of a diversified fixed-income portfolio. It’s also very advantageous to hold TIPS in a retirement account in order to avoid paying the yearly taxes on principal changes that are levied if the TIPS are held in a regular taxable account.

An investor should consider their views on inflation, their risk tolerance in addition to their specific investment goals when making a TIPS allocation. The risk and return attributes of TIPS are not always easily discerned and it’s important that investors understand how these bonds work before making an investment.

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