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NOT TOO LONG ago, Treasury Inflation Protected Security (TIPS) was a relatively obscure investment for safe long-term fixed-income investments. For the first twenty years of the new century, consumer prices were mostly stable or rising at a too-slow-to-notice rate. Why bother with anything related to inflation?
Sadly, persistently low inflation made us complacent on the biggest long-term risk of bond investments — the insidious unexpected inflation that robs us of the purchasing power of our “safe” investments.
Yes, let’s not forget that the biggest risk of bond or bond-like investments is unexpected inflation. Any bond or CD with a maturity beyond a few years must either offer a sufficiently high interest rate to compensate for sudden bouts of inflation, or have its principal adjusted for the inflation actually realized. The former is nearly impossible to find without sacrificing safety. The latter is what TIPS is for.
To be clear, the market and investors always expect some level of inflation. Therefore, a bond’s effective interest rate – measured by its YTM (Yield to Maturity) – must be high enough to not only compensate for “expected” inflation and the uncertainties around it but also provide a meaningful increase in the purchasing power of the original principal.
A concrete example might help. Consider a 10-year US Treasury nominal bond with a face value of $1,000, selling at $1,000 and paying 5% annual interest. The interest rate reflects the expectations about inflation and other factors over the next 10 years. The rate would be lower if market expected lower inflation, and higher if market expected the opposite.
The omnipresence of inflation means we’re likely to lose some purchasing power when we get our $1,000 in 10 years. It won’t buy what $1,000 buys today. By how much? That’s the thousand dollars question (pun intended).
There isn’t a readily available number that explains why that 10-year Treasury Bond yields 5% instead of 3% or 7%. Investors essentially take a leap of faith that annual inflation stays low enough over the 10-year period for the interim interests to compensate for the purchasing power loss, plus some changes.
Most of us are perfectly comfortable assuming that inflation won’t be as high as 5% for 10 years. But are we fooling ourselves? I suggest using an inflation calculator to see for ourselves. Spoiler alert: Late 1960s through early 1980s can be an eye-opening period. How’d we feel if the next 10 years turn out to be something similar?
Think about how you might feel when you safekeep your money in a so-called secure investment, give up higher returns available from risky investments, and then encounter an inflationary regime. Your minimum expectation was that your purchasing power would remain intact and perhaps improve a little by the time your bond matures. Instead, unforeseen inflation erodes your purchasing power and compromises the financial goal the fund was supposed to cover.
Your “safe” investment fails you completely. You realize that it wasn’t safe at all.
If unexpected inflation is so devastating, why are we so lax about it?
I can think of two reasons.
First, our minds haven’t adapted to the reality that, unlike to a “real” asset like a bag of rice or a gallon of gasoline, money in its current form is inherently self-eroding. It slowly loses its worth over time. A hundred dollars sitting around will still be a hundred dollars next year, but it won’t buy the same amount. We don’t intuitively perceive the continuous loss of purchasing power.
Even when we do internalize it with some effort, we get used to the “pace” of the loss. In other words, we view inflation as steady and unexpected inflation as highly unlikely. Alas, all it takes is a single prolonged inflationary period to change that perception. By then, however, the damage to existing fixed income investments may already be done.
Frankly, I’d be very wary of keeping my long-term “safe” money — fund that I need to preserve beyond a three-year horizon – in any form that isn’t protected against unexpected inflation. For bond investments, the most meaningful option would be TIPS.
Why? Because, in addition to being secured by the full faith and credit of the US Government just like any other Treasury securities, TIPS provides three important assurances upfront.
First, it provides protection against unexpected inflation, which is a realized inflation that differs from what we expected when purchasing it. If the actual inflation averages 12% instead of the expected 2%, the principal is automatically adjusted to reflect the actual inflation. No guesswork or unexpected risk involved.
Second, it provides a “real interest rate” upfront that tells us how much the purchasing power of the investment will increase over time, regardless of what the actual inflation turns out to be. Buying a 10-year TIPS with real 2% annual interest means the investment’s purchasing power will grow 2% per year over the holding period, before considering taxes and other factors.
The third aspect is more nuanced. It involves the possibility of inflation being lower than expected, or even negative inflation (aka deflation). Let me elaborate.
If a regular nominal 10-year Treasury Bond offers 5% annual yield and an equivalent TIPS offers a real annual interest rate of 2.75%, the market-implied inflation, the breakeven inflation rate, is roughly 2.25% (5% minus 2.75%). Actual inflation, of course, will be known only after 10 years when the bond matures.
Suppose the actual inflation turns out to be only 1.25%. The nominal Bond investor would end up with more purchasing power than the TIPS investor because the TIPS principle would be adjusted by only the actual 1.25% inflation rate.
The primary objective of the TIPS investor would still have been met: preserving and improving purchasing power by about 2.75% annually. But there would be a “missed opportunity”. The nominal Treasury investor would end up with even greater purchasing power.
Does it mean that a TIPS investor can face an unlimited opportunity cost if inflation turns out to be negative? What happens if the actual inflation is, hypothetically speaking, negative 5%, in a severely deflationary period? Does the TIPS investor get back proportionately reduced principal at maturity?
Thanks to the third assurance of TIPS, the answer is NO.
TIPS guarantees that the principal returned at maturity will never fall below the original face value. During periods of deflation, the inflation-adjusted principal can fall below its face value and the interim interest payments will decline accordingly. But at maturity, the principal is floored at the original principal amount.
Therefore, the breakeven inflation rate, the difference between the yield of a nominal Treasury bond and the real yield of an equivalent TIPS, represents the maximum annual yield advantage that the nominal bond can have over TIPS in an unexpectedly low inflation regime.
To summarize, a TIPS investor gets unlimited protection against unexpectedly high inflation, while accepting a limited opportunity cost should the actual inflation be low or even negative. The magnitude of that trade-off is reflected in the breakeven inflation rate at the time of the TIPS purchase.
An aside: given the destructive impact of deflation on economy and society, policy makers are generally more concerned about preventing prolonged deflation than about preventing modest inflation. Therefore, prolonged deflation is usually considered less likely. Still, we cannot ignore deflation risk altogether and should be prepared for the possibility that TIPS can underperform a nominal bond if inflation runs low.
Therefore, the decision to favor TIPS over an equivalent nominal Bond hinges in part on the current breakeven inflation rate. If it’s low enough, favoring TIPS can be an easy decision. Getting unlimited protection against unexpectedly high inflation is worth accepting the relatively small opportunity cost if inflation comes below the breakeven rate.
There is, however, a cautionary note about buying TIPS bonds in the secondary market, especially older issues.
Consider a 30-year TIPS bond issued 20 years ago and a 10-year TIPS issued within last 6 months. Both might appear to be valid choices if they mature within a few months of each other and offer similar yields. But beneath the surface, one may be more favorable than the other.
The older TIPS will likely have a much higher inflation-adjusted principal because it accumulated 20 years of inflation adjustments. But the protection against unexpected deflation applies only to the bond’s original face value, which is typically $1,000.
In a prolonged deflationary period, the older bond has much more room for its inflation-adjusted principal to decline before reaching the $1,000 floor. The newer issue, whose adjusted principal is much closer to the $1,000 face value, has less exposure to this risk.
Therefore, all else being equal, I’d favor a TIPS with a low inflation-adjusted factor when buying in the secondary market.
All things considered, my vote goes to TIPS for long-term “safe” investments, provided the break-even inflation is reasonably low. For secondary market purchases, however, a high inflation-adjustment factor would give me pause.
Sanjib Saha retired early from software engineering to dedicate more time to family and friends, pursue personal development and assist others as a money wellness mentor. Self-taught in investments, he passed the Series 65 licensing exam as a non-industry candidate. Sanjib is the president and cofounder of Dollar Mentor, a 501(c)(3) nonprofit organization offering free investment and financial education. Follow his nonprofit on LinkedIn, and check out Sanjib’s earlier articles.
Just FYI: A piece by Jason Zweig in the Intelligent Investor newsletter popped up this morning in my Inbox. Sharing for those who can access behind the WSJ paywall:
trk.wsj.com/view/6a5947d0908bb675ed0817ecs3l6e.39sv/6008148d
Curiously, he also emphasizes only the “real yield is high” aspect of TIPS, without mentioning much about the low breakeven inflation factor too. I wonder if the breakeven inflation is 10% and the real TIPS yield is 3% or higher – meaning the nominal yield is 13% or higher – will the experts still consider TIPS to be a good choice because the “real yield” is still high? What would you do?
Thanks for the timely article on TIPS Sanjib. I think that with their recent surge in real yields past 3% they are very attractive at the moment, and would make a great addition to a well-diversified portfolio, especially near or in retirement. For me, the 2.5-3% level represents the “interested, not interested” line, and right now I am definitely a lot more interested. Thanks again!
Thank you for your note. Getting a 2.5+% real yield on top of a reasonably low “breakeven inflation” is attractive indeed, especially for those with a large enough portfolio where 2.5% inflation-adjusted income represents a sizeable portion of the annual withdrawal amount.
The more we know, the better for us!
Thanks for sharing the comparison, Donny. This is very helpful.
Even though I am retired, I cannot bring myself to settle for accepting low returns in exchange for “feeling” safe. Because of our high income stream we have always been and still are 100% invested in Index etf’s.
Thanks L H.
Asset Allocation (division between “risky” vs “safe” investment) is an individual decision, function of one’s risk tolerance, risk capacity, and liquidity requirements. Sounds like you not only have high risk capacity and low liquidity needs but also can tolerate risk. I also assume that by Index ETFs, you mean broadly diversified market-cap dominated Index ETFs, and your “income stream” is inflation-indexed.
If something works for you, that’s great! It may not work for another individual even though they are in a similar financial situation, but have a different attitude towards risk and peace of mind. Ultimately, one should stick to whatever they are comfortable with and can stick to long-term with high level of conviction.
Thank you for your article. I always appreciate reading and understanding investment options. Thank you for explainingTips
Can we trust the government to properly state the inflation rate? I used to think so, but not any more. Therefore, when inflation increases, I expect it to be officially discounted if not outright denied. This would undervalue the bonds.
Thanks, Cammer for sharing the concern. I understand the doubt about properly stating the “inflation rate”. The reality is that, in a market-driven pricing environment, it’s virtually impossible to state a single number that accurately represents the “proper inflation rate” for all individuals/households, or even a majority of households. Everyone’s actual inflation rate is different, as it depends on multiple factors specific to that individual. The stated inflation rate is just an approximation for any particular household, and can never be an exact reflection of every single household.
The important thing to realize is- inflation is there no matter what, and therefore just focusing on the “nominal” amounts can have severe consequences for nominal Fixed Income investments. An inflation-indexed Fixed Income investment is the best-bet available to mitigates those consequences, even though it’s not a perfect solution. Something is better than nothing 😊.
Loved your writing, from the title (Tipsy?”) to the examples. Good education for me. The only thing I would change is the word ‘deflation”— I think “depression” means the same and would grab everyone’s attention. I’ll have a look at your site now. Thanks.
Thanks for the kind words and the suggestion, William.
Thanks Sanjib. Great explanation of TIPS. I am a great believer in TIPS and most of my fixed income is in TIPS.
Thanks, Jerry. I have the same, except short-term ones. It’s a slight headache to create the initial ladder and roll over the unused proceeds of maturing Bonds, but I don’t find the inconvenience to be a very big deal.
Very clearly explained. The question really is can one achieve a similar outcome as a TIP’s using a nominal treasury ladder say 1 – 5 years without the volatility of a long dated TIP’s strategy? I appreciate it’s not an apples to apples comparison but I suspect with duration risk being kept very short (i.e. 2 to 2.5 years), a nominal treasury ladder with frequent maturity can give one a similar outcome as holding a long dated TIP’s ladder with reduced volatility.
Thanks, Akhil. When TIPS are being used for asset-liability matching purposes, there is minimum duration risk. Duration risk applies only to the “market value” of Bonds. With Asset-liability matching, the market value of the ladder is irrelevant because liquidation happens only at maturity. Therefore, the duration risk is inapplicable as well.
That said, if the requirement is just have a safe stash with non-deterministic liquidity requirements, then I wouldn’t take much duration risk myself. An 1-5 year ladder or short-term bond fund might work. Comparing the performance of VTIP and VGSH over a long time period might shed some light about whether to go with nominal ladder or TIPS ladder.
VTIP,VGSH | PerfCharts | StockCharts.com
I would think most TIPS ladder investors are holding each TIPS to maturity, making volatility irrelevant.
Thanks, Randy. That is exactly right. Asset-liability matchers aren’t concerned about volatility of the market value.
After reading your comment I thought that you may find the historical chart – Market Yield on U.S. Treasury Securities at 5-Year Constant Maturity, Quoted on an Investment Basis-Market Yield on U.S. Treasury Securities at 5-Year Constant Maturity, Quoted on an Investment Basis, Inflation-Index useful.
I am one rung away from completing my rolling ladder of 10-year TIPS. As Sanjib points out it is unexpected inflation that robs us of the purchasing power of our “safe” investments.
The key for TIPS to fulfill that inflation protection role is you have to buy individual TIPS, I prefer at the original auction, and be willing and able to hold them to maturity. At least currently, and while I have been buying TIPS for a number of years, the real yield on 10-year TIPS consistently exceeded the real yield on 5-year TIPS. The term you buy is often driven by the need for the funds at maturity. For me a ten year ladder better suits my needs than a five year ladder.
Thanks, William. I have a slightly longer ladder, but I don’t have individual TIPS for the upcoming 3 years (I use a short-term fund instead).
Also, I eye more on the “breakeven inflation” rather than the real yield. I realize many TIPS investors primarily look at the real yield. My thinking is, if I care more about excess return, I’d rather bump up my stock allocation a little, instead of trying to squeeze out incrementally higher yield. E.g., if the yield curve for real yield is negative, I might still go for a longer-maturity TIPS even with lower real yield if the breakeven inflation for the longer TIPS is reasonably low. This is because I prefer inflation protection for a longer period at a reasonable price. This is just my approach, and I do not suggest anyone else to follow the same approach unless they agree with the trade-off.
Like you I also took more equity risk when I was younger to grow our portfolio. I am approximately 15 years older than I think you are. When the final rung of our 10-year rolling TIPS ladder is completed my first intent is to have the ladder funds available to replace the first to die spouse’s lower Social Security benefit cash flow for the surviving spouse.
My second intent is we plan for any remaining TIPS when the second spouse dies to be able to be held to maturity which is the reason we do not want to go beyond 10 years to maturity in TIPS holdings. When my wife and I are both dead, if any of our rolling TIPS ladder is still intact, then our heirs will then have the ability to hold them to maturity. Our heirs can decide to sell or hold based on the market and their needs. All of our TIPS are held in our IRA’s which will be required to be distributed to our heirs within 10 years of death to comply with current tax law.
After we finish filling our 10-year rolling TIPS ladder I intend to begin investing the semiannual, real yield interest income from our TIPS in the global equity index fund where I already invest the equity portion of our portfolio. If we are fortunate to live a really long life and not have major financial events to the downside I would hope a chart of our portfolio would be a rising equity smile.
I agree completely that we all need to plan appropriately based on our own needs and circumstances. Thanks for your article.
Best, Bill
Thank you for sharing your meticulous planning, Bill. A lot to learn from experienced investors like yourself and others on this forum. Appreciate your taking the time to explain the specifics and the rationale behind them.