Treasury Inflation Protected Securities (TIPS) are a unique type of government bond that were first auctioned in January 1997. How do TIPS protect a portfolio from inflation?
Inflation is a bond’s worst enemy. It shrinks the purchasing power of a bond’s future cash flows (coupon payments). TIPS provide protection from inflation by maintaining the purchasing power of those cash flows. The principal of TIPS will move up or down based on the Consumer Price Index (or CPI, which measures the change in price of goods over time). The U.S. Treasury will pay interest on the adjusted value of the bond. For example, if the inflation rate is 2%, a $10,000 3% 30-yr TIPS bond will pay $306 [($10,000 x 2% inflation x 3% coupon rate]whereas a traditional Treasury bond would pay $300.
In a flat to negative economic environment, TIPS can complement Treasury bond holdings as a risk-off position and provide additional portfolio diversification.
There are three factors that make TIPS interesting today. First, as shown in Chart 1 inflation has been trending lower for the past few years. However, in February of 2016, it started to breakout from the long term trend.
Chart 1: U.S. Headline Inflation Rate (2006 to 2016/02)
Second, we look at the breakeven rate (BER) of equal maturity TIPS and traditional Treasury bonds. The BER measures the spread between their yields and reflects inflation expectations that are priced into the market. If inflation runs above the BER, TIPS may outperform nominal bonds. Since 2013, we have seen the BER come down the 2.5% high to 1.21% in February 2016. At that same time, headline inflation of 1.37% was larger than the BER.
Chart 2: Headline Inflation & 10-yr TIPS/U.S. Treasury Break-Even Rate
Data as of 2/29/2016
Lastly, there must be a high conviction that inflation will continue to trend higher. Based on the Fed’s March 2016 economic projections, inflation is expected to rise to the target range of 2% by 2018. Recently, the US dollar has shown weakness and oil prices have continued to rise since the February lows – factors that may push inflation higher from its current level.