Inflation Up, Inflation Protected Bonds Down?
Inflation has skyrocketed this year and has jumped to a 40 year high of 8.6% as of June 2022. But inflation-protected bond funds racked up losses, TIPS down almost 8% this year, so what gives?
Well let’s start with bonds:
Most traditional bonds offer a fixed periodic interest through their maturity at which point the owner – whether it’s an individual or mutual fund – are also paid back the face value of the security. To a large degree, yields on traditional bonds factor in expected inflation. The problem is that over time, inflation will still eat away at the value of that bond. That’s especially an issue for long term bonds. Which is why you currently see long term (duration) bond funds down more than short term bond funds. TIPS solve for that problem by adjusting the amount due to investors based on changes in the consumer price index.
What are Treasury Inflation-Protected Securities?
TIPS first hit the market in the late 1990s and are government-issued fixed-income securities that are backed by the full faith and credit of the U.S. government for timely payment of interest and principal. Treasury Inflation-Protected Securities, or TIPS, are a type of U.S. Treasury security whose principal value is indexed to the rate of inflation. When inflation rises, the TIPS' principal value is adjusted up. If there's deflation, then the principal value is adjusted lower. Like traditional Treasuries, TIPS are backed by the full faith and credit of the U.S. government.
Although there are many measures of inflation, TIPS are referenced to one specific index: the Consumer Price Index, or CPI.
So Why Are My TIPS Down?
Just because inflation is high and rising doesn’t mean that a TIPS fund will be making money. It can easily be the opposite. Often what matters more is what is expected to happen with inflation in the months, quarters and years ahead. Changes in inflation and interest rates do not always move in lockstep with each other. And just like conventional Treasury bonds, TIPS are impacted by movements in the interest rate marketplace.
If Treasury yields increase because of rising inflation, TIPS are hedged. But if yields increase because of rising real yields, as we have right now, TIPS are susceptible to losses.
Broadly, a real yield is a bond yield minus the inflation rate. Since the onset of the pandemic, real yields on TIPS have been negative. That means once investors account for the effects of inflation on their returns, even with the inflation protection offered by TIPS, investors would be essentially losing money on their investment.Put another way, after inflation, the premium you paid for that bond is so high, that you’re not going to make up enough income between now and the time the bond matures to make up for it.
Another headwind for some TIPS investors has been the rise in regular Treasury yields. The yield on the U.S. Treasury 2-year note nearly doubled since the start of the year. Despite the inflation protection, an overall rise in the level of interest rates will still feed through to the TIPS market, putting downward pressure on prices. (As bond yields increase, bond prices decrease)
The turn in performance in early January for TIPS coincided with a shift by the Fed to take more aggressive action to raise interest rates, and pull back on the bond-buying purchases it had been making to pump money into the banking system during the recession.
Putting It All Together
The question for investors starts with the role TIPS play in a portfolio. If it’s simply part of a longer-term asset allocation, that as would be the case, dollar-cost averaging in over time means not having to worry about current valuations.
One way to hedge against falling TIPS prices is to stick with shorter dated maturing notes of less than five years. Because TIPS with shorter maturities are less impacted by rising rates versus longer maturing bonds. TIPS offer a simple and direct method to protect against inflation. The right fund depends on the investment horizon. Shorter-term funds are probably better for shorter holding periods.
