Getting on top of TIPS


We view TIPS as a viable investment for portfolio diversification or a short-term tactical view of oncoming inflation beats, but longer-term outperformance will be hindered by high valuations and stru...
Chief Investment Office17 Aug 2021
Photo credit: AFP Photo


Getting on top of TIPS

Surprise, surprise – inflation is here. Transitory or not, the latest inflation numbers have left many an economist befuddled by their consistent surprises. Taken cumulatively, the six-month rolling consensus beats of both headline and core CPI are at their highest levels in the last 20 years (Figure 1), meaning that the markets have persistently underestimated the monthly inflation prints of late. The prevalence of such misestimates might have resulted in higher inflation expectations recently becoming deeper entrenched within the general market psyche – sparking a greater tilt towards inflation-sensitive asset classes.

TIPS going over the top. This fear of inflation is evident from the demand for assets that protect against the rise of aggregate prices. Aside from commodity and real estate-related assets, even niche securities such as Treasury Inflation‑Protected Securities (TIPS) have seen prices rise way above par values (resulting in real yields trading near all-time lows). Yet the markets may be getting ahead of themselves. We find that TIPS perform well mostly under a unique set of circumstances; not only should (a) inflation be high, but (b) growth also stagnant – stagflationary conditions in short – such that interest rates remain sufficiently low to support elevated TIPS prices. In a post-crisis world where global growth is still rebounding with rate hikes approaching the horizon, several headwinds abound. As such, investors should seek to understand TIPS more comprehensively before jumping into it simply because it accords “inflation protection”.

How do TIPS work? TIPS are government-backed securities issued with maturities of five, 10, and 30 years, with coupons paid semi-annually. The security functions like a bond in essence, except for the use of an index ratio to adjust the principal and coupon payment to match the rate of inflation. By way of illustration, suppose an investor owns USD1,000 in TIPS with a coupon rate of 1%. If there was no inflation as measured by the CPI, then the principal of the bond remains at USD1,000 and the coupon received for the year would be USD10 (1% x USD1,000). However, if inflation rises by 2% at the end of the year, then the principal is adjusted by the index ratio of 1.02 to become USD1,020, while the coupon payment concurrently rises to USD10.20 (1% x USD1,020). Note that this works both ways; the principal and coupon can also be adjusted downward under deflationary scenarios, but the investor is accorded a certain degree of downside protection as they redeem the higher of the adjusted principal or the original principal at maturity.

Figure 1: Largest upside surprises in headline and core CPI in the last 20 years

 

Source: Bloomberg, DBS

Comparing TIPS with Treasuries (UST). While TIPS are explicit in their provision of inflation protection, it may not naturally occur to others that fixed rate treasuries accord a certain degree of inflation insulation as well. Suppose an investor owns a 10Y treasury bond yielding 2%; should inflation only rise by 1% on average in the same period, the investor would still have made real returns of 1% per annum over the life of the security (not bad for an asset class frequently deemed to be inflation-phobic).

How then should an investor decide between TIPS or treasuries?

The crux lies in the difference between the treasury (nominal) yield and the TIPS (real) yield – also known as the breakeven inflation rate. Over the life of the security, should actual CPI inflation average higher than the breakeven inflation, the investor would be better off holding TIPS. Conversely, if actual inflation averages below the breakeven rate, the investor would be better off with treasuries. Presently, investors would only be better off with TIPS if they expect CPI to average above 2.4% in the next 10 years (Figure 2), a relatively tall order given that inflation had only averaged c.2.1% in the preceding 10 years.

Figure 2: TIPS (real) yields are trading near their all-time lows

Source: Bloomberg, DBS

Difficult to solve structural disinflation. Unfortunately, there are no “vaccines” for the secular disinflationary trends that were present before the viral crisis – excessive debt burdens, ageing demographics, technological disruption, and inadequate wealth distribution; forces that would likely prevail in the post-virus world. As such, insofar as prices have risen due to supply chain disruptions, temporal labour scarcity and the like, it would ultimately require more sticky demand-driven forces (lower unemployment, persistent wage increments) for aggregate prices to adjust to permanently higher levels – levels that justify the outperformance of TIPS over treasuries.

Figure 3: UST outperform TIPS most of the time

Source: Bloomberg, DBS

UST frequently outperform TIPS. It comes as no surprise then that UST outperforms TIPS for much of the time (Figure 3), with the only exceptions in the period from 2011-2013 in the thick of the European sovereign debt crisis, as well as in this latest post-crisis recovery period in 2020-2021 with interest rates near the zero bound and inflation spiking off low base effects – both periods where real rates turned deeply negative. Moreover, even as a risk-free security, TIPS do not perform the role of portfolio hedging and volatility mitigation as well as treasuries do, as the previously inflation-adjusted higher principal values of TIPS can be taken back in a crisis when forward-looking markets expect oncoming deflation. This was evident in the large drawdowns in TIPS exchange-traded funds observed in the 2008 Global Financial Crisis and the 2020 pandemic crisis.

Other obscure yet important considerations include:

1.      Relative illiquidity. TIPS often trade with smaller volumes, longer turnaround times, and wider bid-ask spreads than those of treasuries.

2.      CPI mismatch with experienced inflation. Older, more risk averse investors are generally more predisposed to buy TIPS, yet the CPI-based adjustment factor may not represent the consumption needs of the investor demographic (i.e. lower basket weight in health care needs).

3.      Higher taxation. Investors need to pay taxes on the gains from higher inflation-adjusted principal values – gains that have yet to be monetised prior to the sale/maturity of the TIPS security.

The four-quadrant framework for TIPS consideration. We conceptualise a four-quadrant framework based on expectations of growth and inflation to aid investors in decision-making for TIPS investing. In essence, TIPS outperform only under a relatively specific set of circumstances – in a stagflationary environment – where inflation is high, but growth is not strong enough to warrant higher interest rates. Under current conditions where both growth and inflation are rebounding post-crisis, TIPS investors may benefit from the inflation adjustments, but higher growth also increases the odds of rate hikes which can cause the prices of TIPS to fall. Seeing as forward-looking economic projections see both growth and inflation coming back down towards trend levels by 2023, any additional upside for TIPS appear limited.

Figure 4: The growth-inflation quadrants for fixed income investing

Source: Bloomberg, DBS

TIPS for diversification or short-term inflation surprises. All things considered, we view TIPS as a viable investment only for portfolio diversification, or a short-term tactical trade with the view that inflation would continue to surprise on the upside in the coming months. However, we believe the current high valuation premiums of TIPS, along with structurally disinflationary forces, would limit the upside for its outperformance in the longer term.

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