Considering TIPS as a 2021 inflation hedge? Not so fast - Wells Fargo Investment Institute

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Considering TIPS as a 2021 inflation hedge? Not so fast

Wells Fargo Investment Institute - December 17, 2020

by Brian Rehling, CFA, Head of Global Fixed Income Strategy

Key takeaways

  • Treasury Inflation-Protected Securities (TIPS) are inflation-indexed securities designed to provide a real return commensurate with U.S. inflation, plus a small added return.
  • Duration (a measure of a bond’s interest rate sensitivity) is a significant factor in TIPS performance that many TIPS investors overlook.
What it may mean for investors
  • While TIPS can prove effective in the right situation, we believe most retail investors will find TIPS to be a less than ideal inflation hedge.

Record fiscal spending, large debt numbers, and quantitative easing conjure fears of inflation for some. Investors looking for a solution to their inflation concerns may consider turning to Treasury Inflation-Protected Securities (TIPS). After all, TIPS are inflation-indexed securities designed to provide a real return commensurate with inflation, plus a small added return or loss based on market yields. This is in contrast to a standard “nominal” Treasury security in which the coupon and final maturity value are set at issuance—with no adjustment for inflation. While TIPS may have utility for some investors’ inflation concerns, we believe many retail investors likely will find that TIPS do not offer the inflation solution they are seeking.

Breaking down TIPS mechanics

Just like traditional nominal Treasury securities, TIPS are issued with a defined coupon rate that does not change throughout the bond’s life. However, the income an investor receives while holding a TIPS security will change over time as the underlying principal value adjusts depending on the index ratio. At maturity, a TIPS holder receives the original principal value multiplied by the index ratio. The index ratio is important because this is the “inflation protection.” New-issue TIPS initially start with an index ratio near 1.00. The ratio is then adjusted daily for inflation as per the non-seasonally adjusted consumer price index (CPI) for all urban consumers (CPI-U).

TIPS performance

Simplistically, the market value of standard nominal Treasury securities fluctuates based on changes in market yield. TIPS, however, have two primary components that influence price—inflation expectations and market yield. Many investors focus on the inflation expectation component of TIPS while misunderstanding the power interest rate movements have on TIPS performance. 

Our expectation is that U.S. inflation will move higher next year as the economy recovers. If inflation expectations also continue to move higher, an investor could expect TIPS to outperform a comparable nominal Treasury security. However, higher interest rates that often accompany high inflation likely would lead to a negative return for TIPS holders as rising rates push prices lower under such a scenario. The inverse relationship between bond price and bond yield holds true for TIPS. This relationship is most pronounced in longer maturity securities. Most TIPS tend to be longer duration securities. The strong influence of duration in TIPS returns can be seen in Table 1 – which demonstrates that TIPS total returns often fall between intermediate and long-term fixed income.

Table 1. Yearly total return of TIPS compared to intermediate and long-term fixed income indexes

Table 1. Yearly total return of TIPS compared to intermediate and long-term fixed income indexes

Sources: Bloomberg, Wells Fargo Investment Institute, December 9, 2020. Intermediate Term Taxable Fixed Income = Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index; U.S. TIPS = Bloomberg Barclays TIPS Index Long Term Taxable Fixed Income; Long-term fixed income = Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index. See end of report for important index definitions. 

In the right situation

We believe TIPS can offer a substitute for nominal Treasury securities for those investors looking to provide some purchasing power protection to a Treasury portfolio. Investors looking for a high degree of predictability can buy a new-issue TIPS, hold to maturity, and have assurance that their investment will be indexed to CPI. Unfortunately, the current negative real yield environment implies a small negative return after adjusting for inflation over the life of a new TIPS security. Investors also should remember that these assurances come with an opportunity cost of potentially higher returns in other asset classes.

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