Key Questions: Can Treasury Inflation Protection Securities Help Guard Against Inflation?

Some tips about TIPS, which have the backing of the US government and are sensitive to the Consumer Price Index.

Investors concerned with the decline of the inflation-adjusted value of their portfolios should consider assets that benefit from rising prices. The ideal inflation hedge is an asset that can protect against eroding purchasing power and whose returns closely track inflation over the short term and the long term. Treasury Inflation Protection Securities (TIPS) are unique among fixed income securities as their performance is based on changes in the Consumer Price Index (CPI).

The US Treasury issued TIPS for the first time in 1997. Like other Treasury securities, they are backed by the full faith and credit of the US government. Over the years, TIPS have evolved from a niche market to a $1.8 trillion asset class representing approximately 10% of outstanding Treasuries.

TIPS pay interest semi-annually, similar to traditional Treasury-issued bonds. However, unlike conventional Treasuries, the principal value of TIPS increases at the same rate that the CPI rises. Since the TIPS coupon is a fixed percentage of its principal, as principal increases so does the coupon payment.

If TIPS are held to maturity, the Treasury pays investors the higher CPI-adjusted principal. In the unlikely event of deflation, where CPI is negative, TIPS owners will receive the original principal amount.

The inflation-adjusted interest that TIPS pay is referred to as “real yield,” while the interest paid by conventional Treasuries is referred to as “nominal yield.” The difference between real and nominal yields is the break-even inflation rate and primarily reflects investors’ expectations of future inflation. As of Sept. 1, investors were pricing 10-year inflation expectations (10-year breakeven) of 2.45%.

TIPS Misconceptions

TIPS principal is adjusted for realized inflation, but TIPS are not immune from losses during periods of high inflation. For example, year-to-date through the end of August, TIPS have returned minus 7.5% at a time when inflation had surged to 40-year highs.

This performance is a combination of changes in inflation expectations and real interest rates, not the absolute level of inflation. In other words, TIPS help provide protection against unexpected inflation surges as opposed to delivering positive returns during all periods of high inflation. As inflation expectations increase, the break-even inflation rate increases resulting in TIPS outperforming traditional Treasuries. TIPS prices are also heavily influenced by changes in interest rates, particularly real rates. Surging interest rates have hurt the absolute performance of TIPS as the 10-year Treasury has increased from 1.51% at the beginning of the year to 3.13% at the end of August.

This year, the TIPS market has been reacting to both the change in the level of prices as well as the Federal Reserve’s (the Fed) aggressive response to high inflation. On a relative basis, TIPS have outperformed traditional Treasuries by approximately 2%, largely due to the cushion provided by rising CPI. But hawkish rhetoric from the Fed and higher interest rates have caused the value of TIPS to experience precipitous declines.

TIPS perform best when inflation expectations are rising, and real rates are declining. Consider 2021, when the market was anticipating benign inflation conditions and an unanticipated inflation surge: TIPS delivered 5.7% when most high-quality bonds posted negative returns.

Inflation adjustment across all TIPS maturities is the same. For example, 1-year TIPS receive the same inflation adjustment as 20-year TIPS. Since the impact of CPI is the same across all maturities, investors looking for protection against an imminent rise in inflation should consider short-term TIPS, which track inflation more closely over the near term. However, short-term TIPS offer materially lower real yield compared to their longer-dated counterparts, historically delivering lower real returns compared to the broader TIPS market over longer time periods.

Tax Implications of TIPS

Earnings from all Treasury securities, including TIPS, are exempt from state and local income taxes. However, investors should be aware that TIPS are taxed differently from other Treasury securities.

Traditional Treasuries pay tax on any interest payments and capital gains tax when the security is sold at a gain or at maturity if bought at a discount. TIPS owners pay federal income tax not only on interest payments received but also on the CPI-adjusted principal in the year they occur.

TIPS investors do not receive inflation-adjusted principal until maturity or sale, but they are still responsible for income tax on “phantom income” that was accrued but not paid. During periods of rapid inflation expectation changes, such as in 2021, TIPS yield can turn negative, exacerbating taxable client investors’ woes (interest received is less than the tax owed).

Key Takeaways

Many asset classes (e.g., commodities, gold and real estate) are considered effective hedges against inflation. TIPS, however, are the only asset class that is guaranteed by the full faith and credit of the government and is directly indexed to CPI. Over the long term, TIPS have proven themselves to be effective tools in delivering real income to investors and protecting against the unexpected increase in the cost of living. TIPS also offer returns that have a low correlation to traditional assets such as stocks and bonds.

TIPS are designed to protect against price increases over the long term. However, several nuances can heavily influence their performance over short-term horizons. From a holistic perspective, it is critical for investors to try and match their investment horizon with appropriate maturity TIPS. Investors should balance their need for inflation hedging with their risk-return objectives in total when considering TIPS for their portfolio.

For more information, please contact your advisor.