Best Opportunity to Buy Inflation Bonds in the Last Decade

What are Inflation Bonds

We are referring to US Treasury Inflation Protected Securities (TIPS). These securities are linked to CPI inflation and have a place in some investment portfolios as a hedge against inflation.

How Do They Work

As an example, consider a $1,000 face value inflation bond that pays a 2% coupon (interest payment), or $20 per year. A year passes by, and CPI is 7%. The face value of the bond is adjusted upwards 7% to $1,070. Now, the coupon payment is $21.40 ($1,070 * 2%). The interest payment also increased by 7%. An effective inflation hedge in action.

Simply put, inflation bond principle is adjusted upwards at the rate of realized inflation.

TIPS Performance During 2022

TIPS were among the worst performing asset classes in 2022. Consider the following three different TIPS ETFs, VTIP TIP and LTPZ as an example:

VTIP declined 2.96%, TIP 12.24%, and LTPZ 31.68%. LTPZ, and longer maturity individual TIPS, lost more than the S&P 500 Index (the market). Why wouldn’t an inflation security do well during a period of high inflation? TIPS will adjust upwards for inflation and their interest payments will increase as we described in the example above. However, their market prices are interest rate sensitive. The difference in the magnitude of losses among the ETFs is explained by each ETFs interest rate sensitivity. VTIP holds 0–5-year maturity TIPS and has a very low interest rate sensitivity. TIP holds 0–10-year maturity TIPS and has a moderate interest rate sensitivity. LTPZ holds TIPS that don’t mature for 15 years or longer and has a high interest rate sensitivity. In general, the further out the maturity date of the security (bonds), the higher the interest rate sensitivity.

It is important to note that although the market prices of TIPS fluctuate, if the investors intent is to hold them until maturity, they will do exactly what they were supposed to do on the day the investor bought them.

Interest Rate Sensitivity

US Treasuries are sensitive to changes in the real rate (real yield), and changes in expected inflation. TIPS are only sensitive to changes in the real rate, since they are linked (compensate for) to inflation.

Real Yield

TIPS trade with a real yield. When we compare this real yield to the yield on regular treasuries we can extract ‘breakeven inflation’, a proxy for the market’s expectation of inflation. For example, say a 10-yr US treasury trades with a yield of 4%, and a 10-yr TIPS trades with a real yield of 1.5%, then breakeven inflation is 2.5%. Breakeven inflation is the rate that would make the two investments equivalent, i.e., if inflation turned out to be 2.5% over the next 10 years the investment returns on the 10-yr Treasury and 10-yr TIPS would be the same. However, if inflation is higher (lower) then the TIPS (Treasury) investor wins.

Said differently, the yield on US Treasuries contains the real yield plus a built-in inflation premium. The TIPS yield is only the real yield, but investors also get an additional variable premium that depends on what inflation actually is.

The Actual Return on TIPS

An investor in Treasuries could go into the market today and lock in a guaranteed annual return of 3.87% if the investor holds the bond for 10 years. It is a lock, and it is the only guaranteed investment (risk free investment). Alternatively, a TIPS investor will earn the real rate plus realized inflation, which is unknowable ahead of time. However, armed with the breakeven rate the TIPS investor has a good idea of ‘expected return’, which happens to be equivalent to the yield on a similar maturity Treasury.

On the day you buy a TIPS with the intent to hold until maturity you lock in the real rate of return plus inflation. In the rare case of deflation TIPS can be marked down. Overall, TIPS can be considered a low risk/low return investment. When higher real rates are available the relative attractiveness of Tips increases.

The Current Real Rate

The real yield on a 10-YR TIPS is currently 1.58%. Again, if inflation is 2.5% over the next 10 years this investment will return 4.08% per year. If inflation is 4%, the investment will return 5.58% per year. Is this an attractive real rate? Over the past twenty years the average real yield has been 0.84%. At no point over the past 10 years have investors been able to get a real yield this high. A graph of the real rate on the 10-yr TIPS follows:

A real yield of 1.5% hasn’t been available since 2010. In fact, during parts of 2020 and all of 2021 there was a negative real yield on TIPS. During parts of 2011, all of 2012, and part of 2013 TIPS traded with negative real yields. A negative real rate guarantees that you lock in a return of less than inflation. The following graph shows the real rate on the 10-yr TIPS since 2003, the periods with negative real rates are circled in red:

What Should the Real Rate Be

Well, we know that it shouldn’t be negative. TIPS were first issued in the late 1990’s so there is a limited time period to analyze the real rate. There probably isn’t a right answer as the real rate will reflect a required return based on market risk sentiment, among other variables. We wouldn’t be surprised to see it settle in between 1-2%.

The Real Yield Curve

We have used the 10-yr as an example so far. However, the Treasury issues TIPS in maturities up to 30 years. The following is the Real Yield curve from 1 year out to 30 years:

The highest returns are available at the short end of the curve, from one year out through three years, and a short-term ladder can be built with a real rate north of 2%. These short-term TIPS have very little interest rate sensitivity, so their prices won’t fluctuate much. In addition, upon maturity they turn into cash and provide liquidity to the portfolio. Of course, the short duration of these TIPS introduces reinvestment risk, i.e., the cash inflows out 1, 2, or 3 years may have to be reinvested at future market rates that could be lower, or higher, than today.

The Real Yield Curve One Year Ago

In the following chart the current real yield curve is still in green, however, we have also shown what the yield curve looked like on Jan 1, 2022, with the yellow curve. The entire curve was negative. In the panel below the curves the gold bars represent the change in the real yield over the last year:

Longer term real rates have all moved higher by over 2%, a massive move, but short end rates have moved much higher. The 1-yr rate has changed over 5%, from negative 3% to positive 2.6%, in just one year. This extraordinary move at the short end was influenced by the federal reserve hiking interest rates throughout 2022.

TIPS Vs Treasuries

This decision relies on an investor having an estimate of future inflation. The winner of the competition will be determined by realized inflation. If the investor thinks realized inflation will be higher (lower) than the breakeven inflation rate, then the investor buys TIPS (Treasuries). However, a retiree with a pension that is not inflation-adjusted, like a Tier 2 FDNY retiree, need not concern themselves with this competition. TIPS are the superior choice. If inflation is higher than the breakeven rate, then the retiree will have hedged unanticipated inflation and outperform the Treasury investor at a time when their pension is losing purchasing power. If inflation is lower than the breakeven inflation rate then the TIPS investor will underperform the Treasury investor, but what is far more important in this scenario is that the pension retains its purchasing power. The competition with the Treasury investor is irrelevant.

This decision is easy for a Tier 2 FDNY retiree, TIPS lower the retiree’s inflation risk while Treasuries concentrate it.

Conclusion

US TIPS are a useful instrument to hedge inflation in retiree portfolios. Like any publicly traded security TIPS prices fluctuate, and the main driver of price fluctuations for TIPS is changes in the real rate. Real rates higher (lower) drive TIPS prices lower (higher). This was on display in 2022 with TIPS prices declining across the board. TIPS prices decreased even though they did their job, principal was adjusted at the inflation rate and the bonds paid out higher interest payments. These price losses were driven by the extraordinary move higher in the real rate. That was last year, and the repricing has made TIPS far more attractive than they were a year ago when real rates were negative. Current real rates from one month out to thirty years are at the most attractive levels in over a decade. And while there is no guarantee that real rates won’t move higher, we think the current real rate is an attractive one to lock in. In our opinion, the shorter maturity TIPS are the most attractive, from 2023 through 2026. They have a higher real rate of return, have less price volatility, and will result in portfolio cash inflows when they mature over the next few years. TIPS are the smart fixed income choice for Tier 2 FDNY retirees that have a pension asset with a significant exposure to inflation risk.