What Are TIPS and How Do They Work?

TIPS, or Treasury Inflation-Protected Securities, are bonds issued by the U.S. government. Accordingly, they carry the same credit risk as Treasury bonds, which were addressed in Chapter 5. That is to say that TIPS, like Treasuries, are widely considered to be a risk-free asset, since the U.S. government holds the world's reserve currency and has the capability to print U.S. dollars to repay its obligations. If you owed me money and had the flexibility to print it out of thin air, I would not be too worried about being paid back. This is particularly true given the long-term negative consequences of defaulting on your debt.

TIPS generally pay a coupon that is less than that paid by Treasuries. This is because TIPS returns are inflation-adjusted (measured by using the CPI, or the consumer price index). For example, if you buy a TIPS bond that provides a 2 percent yield to maturity, your total return will be 2 percent plus actual inflation if you hold the bond to maturity. If inflation turns out to be 3 percent, then you get 5 percent (2 percent plus 3 percent). The main idea behind a TIPS bond is to provide investors the inflation protection that they do not get with Treasuries. Other than the inflation component, TIPS and Treasuries are the same. Of course, that inflation factor makes a world of difference (as you may have guessed).

Another way to compare Treasuries to TIPS is by calculating the break-even inflation rate. For instance, if a 10-year Treasury offers a yield of 4 percent and a comparable maturity TIPS bond has a yield of 1 percent, then that implies that the market is discounting inflation to be 3 percent over the maturity time frame. This must be true because the two bonds are identical otherwise (same maturity and credit quality). The only difference between the two is that one provides a yield without inflation protection and the other offers a lower yield with inflation protection. As an investor, you have an opportunity to choose between the two securities. Therefore, if you feel that inflation will be greater than the break-even rate—3 percent in my example—then you would opt for the TIPS bond. If you were concerned that inflation would come in less than 3 percent, then you'd buy the Treasury because it would provide a higher total return if you are correct.

You might sensibly consider TIPS to be one of the safest investments you can make: They are bonds and therefore your principal is safely returned to you at a predetermined maturity date. Your investment is guaranteed by the U.S. government and is backed by its ability and willingness to print money to pay you back. For lending your money, you are paid a fixed interest rate that is also guaranteed. Additionally, and perhaps most importantly, your investment is protected against the long-term negative consequences of inflation. Other bond investments do not share this benefit. Treasuries, for instance, are just as safe in terms of principal and interest payments but because they are not linked to inflation you are taking the risk that the money paid back to you will be worth less due to inflation. Thus TIPS are arguably safer than Treasuries, since an investment in this asset class does not contain inflation risk as does an investment in Treasuries.

For example, if you lend me $100 today and I promise to pay you back in 10 years, then the expected rate of inflation is a big factor in the amount of interest you will charge me for that loan. If you anticipate inflation to be low, then less interest is required. However, if you suspect that inflation rates will spike, then you will demand a higher rate of interest in order to be compensated for the diminished purchasing power of your money. With TIPS, this concern is generally eliminated.

The Conventional View That the Yield of TIPS Is Too Low and Why It's Flawed

The same argument that is widely used against Treasuries generally applies to TIPS. Most investors look at the low yield of TIPS and conclude that the upside return potential is limited while the downside risk is too much to warrant an allocation to this asset class. The rationale is that a low yield is unsustainable and will inevitably rise back to historical norms, and that rising yields are a negative influence on the price of TIPS and therefore TIPS must be a bad investment. The majority of investors view this unique asset class in this light. As a result, TIPS are heavily under owned in conventional portfolios. In fact, the standard 60/40 allocation completely excludes TIPS. Absolutely zero allocation!

It seems that TIPS are not widely followed securities and are misunderstood by many investors relative to Treasuries and other nominal (as opposed to inflation-linked) bonds. This is partly understandable as TIPS are relatively new securities. In the United States they were first created in 1997, while other parts of the world initiated similar instruments a few decades earlier. The confusion is probably due partly to this asset class's relative young life and partly because of its distinctive structure. It simply does not function like most other bonds because it is hedged against inflation (one of the greatest enemies of a bond holder).

The manner in which TIPS deliver returns is a little different from many other asset classes. As is the case with Treasuries (and other asset classes), the excess returns of TIPS above cash depend on how future economic conditions transpire relative to discounted rates. The market's expectation of future shifts in cash rates over time is reflected in the TIPS yield curve. The difference here relative to the Treasury yield curve is that the TIPS yield curve is net of inflation. This is called the real yield curve and is used because TIPS returns are inflation-adjusted. Thus, changes in actual inflation are paid through TIPS so the price needs not vary to reflect shifts in conditions (as is the case with Treasuries). Therefore, the excess returns of TIPS above cash depend on how real rates of cash (that is, cash yields net of inflation) change over time relative to how they were expected to shift with the passage of time. The only difference between future returns for TIPS versus Treasuries is that TIPS use the real yield curve and Treasuries use the normal, or nominal, yield curve.

For instance, a very steep real yield curve indicates the anticipation by the market that real yields will rapidly rise over time. An easy way to think about the real yield is to take the nominal yield and subtract inflation. Unlike nominal yields, real yields can be negative if inflation is higher than nominal rates. If nominal one-month rates are 1 percent and inflation is 3 percent, then the real yield is –2 percent (1 percent minus 3 percent). If the yield for 10-year TIPS is 3 percent with 3 percent expected inflation, then the real yield at 10 years is 0 percent (3 percent minus 3 percent). These represent two points on the real yield curve: one at one month and the other at 10 years. Following this process through various maturities sets the real yield curve from short- to long-term maturities. As cash rates change through time and as the rate of inflation shifts, the actual real yields unfold year by year. If the real yield curve is upward sloping and steep, then that implies that real yields are anticipated to rise quickly over time. If they rise less than priced in, then TIPS outperform the real yield of cash.

From this analysis, you should recognize that TIPS could produce attractive excess returns above cash regardless of the starting yield. It is the low yield of real cash that is unusual and not the low yield of TIPS. The focus should be on excess returns above cash, so a low or zero cash yield simply lowers the hurdle. This is a major oversight in conventional thinking.

Another way to think about the potential performance of TIPS during rising interest rate environments is as follows: If interest rates rise due to increasing inflation, then there are two potentially offsetting effects on TIPS pricing. Rising cash rates to fight inflation are a negative if the increase is greater than that discounted by the yield curve. However, rising inflation is a positive for TIPS. Depending on how much either goes up, the net effect on TIPS could be positive or negative. In contrast, Treasuries generally do poorly no matter what the reason for interest rates rising (assuming they rise faster than discounted). TIPS at least have some upside potential if interest rates rise due to increasing inflation.

TIPS Viewed Through a Balanced Perspective

The two key insights about each asset class that I focused on when discussing equities and Treasuries will be repeated with TIPS. The economic environments in which TIPS are biased to outperform will be explored and the logical connections analyzed. Since limited actual history is available for TIPS, the reasonableness of the cause-effect relationships is even more significant than it is with other asset classes. Also, it will be critical to consider the importance of including higher-volatility TIPS rather than lower-volatility bonds in a balanced portfolio. Ultimately, my objective is to help you analyze this asset class within the context of how it fits within a well-balanced asset allocation mix.

Putting It Together: Rising Inflation and Falling Growth

TIPS are biased to outperform their average excess return above cash during rising inflation and falling growth economic climates. Table 6.1 summarizes the data that supports the conceptual conclusions just covered.

Average Excess Return for All Periods (Good and Bad)	Good Environment (Avg. Excess Return)	Bad Environment (Avg. Excess Return)
4.6%	Rising inflation (10.7%)	Rising growth (1.1%)
	Falling growth (7.9%)	Falling inflation (−1.1%)

As can be expected, TIPS far outperformed their average returns during rising inflationary periods. Falling growth climates also produced very strong returns. Unsurprisingly, the opposite environments—rising growth and falling inflation—delivered subpar results, with falling inflation actually producing negative excess returns.

How can the returns be negative? Returns below the return of cash do not suggest that deflation existed during these time frames. In fact, newly issued TIPS bonds are deflation-protected, meaning that if inflation turns out to be negative, then zero inflation will be used to calculate the return of TIPS. However, excess returns may still be negative because the returns are based on what happens versus what was expected to occur. If the market is discounting high inflation rates and inflation fell, then the excess returns above cash could very easily be negative. This is often true even if there was positive inflation and could even be true if there was high inflation. Again, it is all about how the future transpires relative to discounted conditions.

Another understandable conclusion from Table 6.1 is that at 4.6 percent, the average excess return above cash for TIPS may seem high. Because TIPS history only goes back to 1997, actual data prior to that period does not exist. Due to the relatively small data set and the desire to use longer historical returns for all the asset classes to cover a wider range of historical economic environments, I have used simulated TIPS data for periods prior to 1997. Bridgewater Associates, one of the originators of TIPS (it assisted the U.S. government in creating TIPS in the mid-1990s), prepared the simulation. Bridgewater used its deep understanding of the mechanics behind TIPS pricing and applied its insight to actual historical economic developments to create a simulated TIPS return stream going back to 1927. Conceptually, the numbers make sense. During rising inflationary and falling growth climates TIPS outperformed. Conversely, TIPS underperformed during the opposite set of economic outcomes. Moreover, the simulated results very closely align with actual returns since 1997, further adding credibility to the proprietary methodology used to create the return series. Note also that since 1997 TIPS excess returns have been even stronger than the longer-term data presented here (7.4 versus 4.6 percent).

Simulated data is undoubtedly imperfect. For this reason, you should emphasize the relationship between various economic outcomes and return patterns rather than the absolute returns produced by the simulation. The former is far more reliable looking forward. It is the logical sequence of why investing in TIPS within the context of a well-balanced portfolio that should be the prevailing insight. The numbers help support the concepts, but you should not depend overly on the data, particularly since most of what is represented did not actually happen. What we can be confident about is that TIPS are biased to outperform during rising inflation and falling growth economic environments and few, if any, other asset classes share that beneficial bias.

The same data can also be observed over longer time frames. Figure 6.1 illustrates rolling 10-year TIPS excess returns. Periods of outperformance and underperformance seem to logically correspond to the economic bias I have described.

The Crucial Role of TIPS in the Balanced Portfolio

TIPS have a prepackaged bias to rising inflation and falling growth as depicted in Figure 6.2.

Every component of the balanced portfolio serves a critical role. TIPS, however, are possibly the most influential of the asset classes. As I have discussed throughout this book your objective in portfolio construction should be to ensure that you have efficiently covered all four key economic environments (rising growth, falling inflation; falling growth, rising inflation; rising growth, rising inflation; and falling growth, falling inflation) with the asset classes you have selected. As it turns out, some of the boxes are easier to fill than others. There are many asset classes that are biased to do well during rising growth environments. Falling inflation is also easy to cover since both stocks and bonds, which are widely used, benefit from this outcome. There are a handful of asset classes that are predisposed to outperform during falling growth periods, but after that the list starts to shrink. As previously mentioned, even fewer benefit from rising inflation. In fact, the list of good candidates for this environment is quite limited. Therefore, due to the scarcity of viable replacements to cover the rising inflation and falling growth outcomes, TIPS serve as an excellent diversifier for most portfolios.

Since the growth-inflation boxes for TIPS are exactly the opposite from those used for equities, you might conclude that a balanced portfolio can be constructed by using just these two asset classes. After all, between the two all four potential economic outcomes would be covered. Indeed, this is a valid argument, and a portfolio that only consists of these two assets would probably be more balanced than conventional portfolios.

However, one unique nuance about the timing of TIPS returns should be mentioned. Since TIPS returns are adjusted for actual inflation, it is generally shifts in actual inflation that impact TIPS returns rather than shifts in expected inflation (or how future inflation transpires relative to expectations). This distinction is significant in terms of the exact timing of the underperformance and outperformance of TIPS. Because of the fact that TIPS are bonds that account for the current inflation rate, over the short-term their price is not impacted by shifts in future expectations of inflation changes. However, over longer time periods the changes in inflation do make a difference in the returns of TIPS, because investors receive returns reflecting the inflation that actually transpires. This characteristic is only important because of the potential timing mismatch between TIPS returns and those of the other asset classes. Since the returns of the other asset classes mentioned—equities, Treasuries, and commodities—are impacted by changes in inflation expectations and how inflation transpires relative to what had been expected, then the key impact to the returns of these asset classes is how these variables shift over time. Consequently, TIPS may not move if inflation expectations suddenly increase, as would the other asset classes. Of course, over time TIPS do react to these changes, but the shift in returns experiences a lag relative to the other asset classes.

Think of it this way: TIPS prices over the short run are based on changes in growth while shifts in inflation flow through TIPS over a longer time frame. In contrast, the other three asset classes experience changes in the current price from shifts in growth as well as inflation over the short run (as well as the long run). The upshot is if inflation expectations suddenly jump, then the lag in TIPS returns reacting to this new environment may not immediately be reflected in the price. This means that the balanced portfolio may underperform for a short time until TIPS returns catch up to the change in conditions. They need to catch up because the other three asset classes would have already reacted to the shift in inflation expectations while TIPS experienced a delayed reaction. Over time, this distinction is smoothed out so it is not that important over the long run. I only mention it so that you are aware of this unique dynamic as it relates to TIPS. One way to mitigate this factor is to own commodities (which will be covered in detail in the next chapter) as an inflation hedge because this asset class does tend to react immediately to shifts in inflation expectations. For this reason, there is a benefit to further diversify a balanced portfolio by adding more assets within the framework presented.

Summary

In summary, TIPS are an excellent diversifier that cannot easily be replaced. Their role within the context of the balanced portfolio is crucial because they cover the two economic scenarios that are most often underweighted: falling growth and rising inflation. Moreover, the low starting yield should not dissuade you from adding them to your portfolio because attractive excess returns above cash are still achievable looking forward.