Inflation Protection: Why You Should Think Twice about TIPS | Lord Abbett
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Market View

Investors may not realize the degree of interest-rate risk that TIPS carry. We believe there are more attractive approaches to protecting portfolios against inflation.

Read time: 5 minutes

Inflation has been at the forefront of investors’ minds in recent weeks. As we noted in the previous Market View, an increase in U.S. economic activity, along with a new round of fiscal stimulus on the back of very accommodative monetary policy has led many to fear increasing inflation pressures and higher interest rates. Recent headlines have highlighted the sharp increases in prices of copper, steel, lumber, used cars, poultry, and other goods. There is an ongoing debate whether these increases are transitory, and we return to a low-inflation world, or if this is the beginning of a more persistent trend of higher inflation. Given this uncertainty, how might investors position their portfolios for a potential uptick in inflation?

Fund flow data from Morningstar indicate that investors have been preparing for inflation by increasing allocations to U.S. Treasury Inflation Protected Securities (TIPS). The Morningstar Inflation Protected Bond Category, which predominantly consists of funds that invest primarily in TIPS, received over $50 billion in net inflows in the 12 months ending in March 2021, with over 70% of those flows going to passive funds. Investors look to TIPS as a hedge for their fixed income portfolios, as fears of higher inflation can lead to higher bond yields and negative returns for high quality bonds. However, as we have highlighted before, TIPS may not always provide the protection that investors expect.

TIPS: The Right Solution?
TIPS are Treasury securities that are indexed to inflation. The principal of a TIP security is adjusted semi-annually according to changes in the Consumer Price Index (CPI). With a rise in the CPI index, the principal value of the security increases. While investors may be attracted to the inflation-adjustment component of TIPS, they might not be interested in increasing exposure to another characteristic factor of these securities: longer duration. For example, the effective duration on the Bloomberg Barclays U.S. TIPS Index (TIPS Index) is approximately 8 years (as of March 31, 2021). As with other government-related securities, an increase in real (inflation-adjusted) yields can lead to negative price movements, something that TIPS investors experienced in the 2021 first quarter.

Figure 1 tracks the yield on 10-year US TIPS in recent years. In the period covered by the chart, 10-year TIPS yields were as high as 1.2% in late 2018 before steadily declining through 2019, then plunging below negative 1.0% after the COVID-driven economic shutdown. Yields remained near that level until  early January, when real yields  increased by about 50 basis points by March, resulting in a 1.5% loss on the TIPS Index in the first quarter.

 

Figure 1. A Recent Rise in Real Yields Has Stung TIPS Investors
Yield on 10-year U.S. Treasury Inflation Protected Securities (TIPS), January 1, 2017–May 7, 2021

Source: Bloomberg. Data as of May 7, 2021. Real yields are as adjusted for the rate of inflation. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

In the March 15 Market View, we reviewed performance of various asset classes during periods of rising rates, as measured by the yield on the 10-year U.S. Treasury note, pointing to the performance of shorter duration and more credit-sensitive strategies during these periods. Today, we update the table of performance in Figure 2 to include the Bloomberg Barclays U.S. TIPS Index. While credit sectors such as high yield bonds and bank loans are negatively correlated with U.S. Treasuries, U.S. TIPS tend to be positively correlated with U.S. Treasuries.  

Looking back at previous periods of rising nominal U.S. Treasury yields, the performance of TIPS has been mixed: sometimes positive, sometimes negative, but always trailing credit and equity-related asset classes as summarized in Figure 2.

This may lead to a disappointing experience for investors who have looked to TIPS to protect their bond portfolios from an uptick in interest rates due to uncertainty about inflation. While TIPS may benefit from an uptick in inflation, an increase in real yields may provide a headwind.

 

Figure 2. TIPS Have Lagged Credit and Equity-Related Investments During Periods of Rising Yields
Returns during recent periods of greater that 100 basis point increases in the 10-year U.S. Treasury yield

1FTSE 10 Year Treasury Bond Index. 2Bloomberg Barclays U.S. Aggregate Bond Index. 3Bloomberg Barclays U.S. TIPS Index. 4ICE BofA U.S. Corporate BBB-Rated 1-3 Year Index. 5Credit Suisse Leveraged Loan Index. 6ICE BofA U.S. High Yield Constrained Index. 7ICE BofA Convertibles Index. 8S&P 500 Index.
Source: Morningstar. Data compiled March 10, 2021. Returns for periods of greater than one year have been annualized. One basis point equals one one-hundredth of a percentage point.
Performance data quoted reflect past performance and are no guarantee of future results. Performance during other time periods may have been different or negative. Other indexes may not have performed in the same manner under similar conditions. Source: Morningstar. For illustrative purposes only. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Looking more closely at the most recent period, the yield on the 10-year US Treasury started moving higher last August, primarily driven by increasing inflation expectations, while real yields remained low. This initially was a positive backdrop for TIPS. But as real yields jumped higher in the first quarter of 2021, TIPS have given back much of those gains.

Even after this move, real yields still have a long way to go just to get back to positive territory. As of Friday, May 7, 10-year U.S. TIPS traded at a negative yield of 0.9% and would have to rise another 200 basis points to return to the levels seen in late 2018. Five-year TIPS trade at an even deeper negative yield of -1.9% and would have to rise 300 basis points to return to 2018 levels  While not a prediction, it may be worth considering how TIPS may react in such an environment of real yields returning to more normal levels.

A Different Approach to Inflation Protection
There are alternatives for fixed-income investors who want to counter the effects of an increase in inflation on their portfolios without exposing themselves to additional duration risk. One strategy they might consider employs a portfolio of professionally managed swaps tied to the U.S. Consumer Price Index (CPI). By capturing movements in inflation expectations and changes in headline CPI, the value of CPI swaps is more directly targeted toward inflation than TIPS. In essence, CPI swaps can provide exposure to the inflation component that TIPS are desired for, while leaving behind the duration exposure. Unlike TIPS, CPI swaps historically have a negative correlation with U.S. Treasuries which may lead to more efficient diversification for investors' fixed income holdings.

By combining a portfolio of short-term, credit-sensitive bonds with an overlay of CPI swaps, asset managers have the potential to create an inflation protection strategy with a higher yield and lower duration than a traditional TIPS strategy. This strategy may provide the inflation protection that investors are seeking with little duration risk and offer diversification benefits for core fixed-income holdings.

A Final Word
As we have stated previously, it is very difficult to accurately predict moves in interest rates and inflation with any consistency. It remains to be seen if recent inflation pressures are transitory or may be more persistent. But in the meantime, uncertainly around the inflation picture may put upward pressure on U.S. Treasury yields. To position for a move to higher U.S. Treasury yields, investors may want to lower duration exposure and look to short term bonds, high yield bonds, floating rate loans and other credit and equity-related securities. Investors may be well served by looking to add exposures to these credit sectors to diversify the duration exposure of core bonds. And to position for higher inflation, rather than simply adding TIPS, a more targeted approach to inflation such as the one we’ve outlined here may be prudent.

 

A Note about Risk:  The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes. The longer the maturity date of a security, the greater the effect a change in interest rates is likely to have on its price. 

Market forecasts and projections are based on current market conditions and are subject to change without notice. No investing strategy can overcome all market volatility or guarantee future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

TIPS (Treasury Inflation-Protected Securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the CPI-U. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semi-annually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.

basis point is one one-hundredth of a percentage point.

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value.

The Consumer Price Index (CPI) measures the price changes f or each item in a predetermined basket of goods and services, and the inputs are weighted according to their importance to consumers.

Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.0 to -1.0.

.

CPI Swaps are derivative instruments used to hedge inflation risk by transferring inflation risk from one party to another through an exchange of cash flows.

Duration is a measure of the sensitivity of the price of a fixed-income asset to a change in interest rates and is expressed in years.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The Index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. TIPS Index is an unmanaged index comprised of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

The FTSE 10 Year U.S. Treasury 10 Year Bond Index is designed to measure the performance of U.S. Treasury securities with a maturity of 10 years.

The ICE BofAML U.S. High Yield Constrained Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

The ICE BofA U.S. Corporate BBB-Rated 1-3 Year Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.

The ICE BofA U.S. Convertible Index tracks the performance of publicly issued U.S. dollar-denominated convertible securities of U.S. companies. Qualifying securities must have at least $50 million face amount outstanding and at least one month remaining to the final conversion date.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product, or service may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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