Index Capital Insights Issue #3

Treasury Inflation Protected Securities (TIPS) exhibit properties that most investors should find very appealing. They are regularly issued in 5, 10, and 30-year maturities by the US Treasury, and rank among the most widely available, lowest cost, and least correlated long-term complements to stock portfolios.

While TIPS are not typically associated with index investing, their principal value is indexed to the Consumer Price Index for All Urban Consumers (CPI-U). To be precise, TIPS are “index-linked” investments rather than index-tracking investments because their year-to-year total return is impacted by changes in real (inflation-adjusted) interest rates in addition to changes in the underlying index. Nevertheless, as noted by Victor Haghani and James White[1], “For (investment) horizons similar to the bond’s maturity, (TIPS) can be treated as risk-free, or as the minimal risk asset, as they’re the closest an investor can get to locking in a forward amount of real consumption.” (shout-out to Messrs. Haghani and White for a compelling read which I highly recommend)

Of course, for investment horizons other than a given TIPS’ maturity, interest rate risk is an important factor to consider in the design of your investment policy. Which is why, conventionally, the “risk-free” moniker is reserved for Treasury Bill rates. However, inflation-linked bonds are more effective than T-bills for locking in future inflation protected income streams. T-bills were not designed for this objective. Therefore, investors should be deliberate about which specific risks they seek to accept, hedge, or mitigate through portfolio construction. T-bills, like other cash equivalents, are ideal for short-term protection of nominal principal. TIPS are suited for long-term protection of inflation-adjusted buying power.

The price of locking in future buying power

As in all investment activities, price matters. TIPS are no different. Think of a given TIPS’ yield as the current price of locking in future inflation-adjusted buying power expressed as the real yield you will earn through the bond’s term. Your total realized nominal return will pretty much be locked in (aside from coupon reinvestment) as the stated TIPS real yield plus the change in CPI-U. In other words, the risk of unexpected increases in CPI is hedged and you earn the stated TIPS yield over and above whatever realized inflation turns out to be during the bond’s term. As of mid-March, 10-year TIPS yields are hovering a bit below 2%. Looking at history in Chart 1, persistent real rates of 2% or more have not prevailed since before the Great Financial Crisis. Since then, even rates over 1% real were relatively scarce.

Comparing a real rate of about 1.9% that you can lock in with 10-year TIPS with a real rate of about 3%, implied by the prevailing Cyclically Adjusted Price Earnings (CAPE) ratio of about 32, for US stocks that you cannot lock in shows that investors are wise to consider allocating some of their portfolio to TIPS. Add to that the benefit of low correlation to stocks, and the case for TIPS investment becomes even more persuasive.

Chart 1

TIPS are not without quirks, and I’ll discuss two notable ones. First, they can trade and be originally issued at negative yields. In Chart 1, contrast the recent 10-year yield with the pandemic period. What are the implications of buying TIPS at a negative yield?

To put some context around the question it helps to think about an important distinction between real and nominal yields, which are not adjusted for inflation. Comparing the US TIPS yields during the pandemic period with that of Germany’s 10-year nominal yield highlights the difference. Chart 2 shows 10-year German Bund yields were persistently negative during the pandemic. In the US, real 10-year yields went negative but nominal 10-year yields did not.

Chart 2

Buying a nominal bond at a negative yield results in locking in a negative total return. TIPS work differently. Because their cash flows are indexed to CPI-U, and are not pre-determined and fixed, it is possible to buy one at a negative (real) yield and still earn a positive nominal return. If the future sum of all cash flows is greater than the amount paid at purchase, you will have a positive nominal return. That said, it was not a great deal to buy TIPS during the pandemic period because you would have locked in a negative real return. In other words, even if your nominal return turns out to be positive, it will trail the rate of inflation over the bond’s term.

TIPS taxes

The second idiosyncrasy of TIPS I’ll talk about is their taxation. While TIPS’ income is tax-exempt at the state and local level as with other treasuries, increases of indexed principal are taxed federally as they accrue during the life of a TIPS security. Paying tax on coupon interest received is one thing, but paying tax on accrued principal not actually received until maturity is another. Unfortunately, this “phantom income” must be recognized in the year it occurs.

Therefore, it pays to consider TIPS’ asset location. Because of the current tax liability generated by increases in TIPS’ principal, consider investing in tax deferred accounts such as traditional IRAs and 401(k)’s, or tax-free accounts such as Roth IRAs, Roth 401(k)’s, and Health Savings Accounts (HSAs).?

For secure inflation protection in taxable accounts consider a close relative of TIPS, inflation-linked US savings bonds called I Bonds. I Bonds are also indexed to CPI-U but differ from TIPS in terms of mechanics and taxation. Unfortunately, buyers are limited to $10,000 per year per individual (plus another $5,000 if you buy paper bonds with a tax refund). Income tax recognition is deferred until the bonds are redeemed, and they earn interest for 30 years after issuance. Notably, their fixed rate (cash flows are driven by a fixed rate at issuance for the life of each bond plus a variable rate that is linked to CPI) is never less than 0%. Therefore, even when TIPS traded at negative yields you could still buy I Bonds at 0% real. These bonds are not “marketable securities”, which means they do not trade in a secondary market like TIPS. However, they are redeemable through the US Treasury after 1 year from issuance. If you hold an I Bond for less than 5 years, you lose 3 months of interest at redemption.

Tying it all together

You’ve heard it before – nothing is more consequential to long-term risk and return than asset allocation. It bears repeating, if only to highlight the strategically important tradeoff to be negotiated between risky growth assets like stocks and long-term risk-free assets like TIPS. The central question you, as an investor, have to answer is how much of your future wealth and income do you want to lock in at forward inflation-adjusted levels and how much do you want to risk on taking a shot at doing better.

The good news is that TIPS are ideal stock portfolio diversifiers. I mentioned low correlation to stocks a couple of times, and Table 1 shows supporting data for the period from January ’20 to Feb ’24. The intermediate TIPS fund exhibited low positive correlations with US stocks (0.07) and commodities (0.16). Its correlation with the nominal bond fund was higher at 0.71, but TIPS nevertheless can be expected to provide some diversification with respect to other fixed income assets.

Table 1

Implementing TIPS investments can be done through mutual funds, exchange traded funds (ETFs), or direct purchase of individual securities in a brokerage account or at Treasury Direct. Brokerage firms typically facilitate participation in treasury auctions at no, or very little, cost. While the Treasury Direct website may be a bit quirky for some, it is very informative and there is no charge for buying savings bonds or participating in marketable securities auctions. Buying a fund is the costliest alternative, but funds may be more convenient for regular periodic purchases and other purposes. On some investment platforms, such as certain retirement plans, trading in individual securities is often not permitted and funds may be the only alternative. If you go the fund route, make sure to pay attention to the investment policy including a fund’s target maturity range, the gross and net expense ratio, transaction costs, and other relevant information and risks. It’s a good idea to shop and compare various alternatives available in your specific account(s) before committing to any fund.

If you are curious about TIPS history since their inception in 1997, Treasury Direct has a full history of TIPS auction results. TIPS Watch, by David Enna, is a highly informative and authoritative source for updates and detailed information on the entire inflation-linked treasury-issued bond market including both TIPS and I Bonds.

Unexpected inflation is a prime catalyst for equity market corrections, as investors reassess which companies are dominated by an opportunity to raise prices to customers versus a threat to pay higher prices to suppliers and employees. Owning TIPS is an almost bullet proof method of locking in real inflation-adjusted future buying power and providing diversification to a portfolio of otherwise risky holdings. With real long-term rates approaching 2%, or even higher for horizons beyond 10 years, investors are wise to take advantage of current pricing in the TIPS market.

[1] The Missing Billionaires: A Guide to Better Financial Decisions, p.204. Wiley, 2023.