Despite the Federal Reserve’s 2% inflation target, long-term U.S. consumer inflation has averaged … [+]
Treasury inflation-protected securities (TIPS) share many characteristics with typical U.S. Treasury bonds, including semiannual interest payments and the backing of the full faith and credit of the U.S. government. They differ because the principal and interest are adjusted for inflation based on the Consumer Price All Urban Non-Seasonally Adjusted Index (CPI) with a three-month lag. The principal value is adjusted based on inflation, with any accretion paid at maturity. The principal value cannot fall below the original par value if deflation occurs. While the coupon rate is fixed on TIPS, the semiannual interest payment is based on the inflation-adjusted principal.
With the details of the securities out of the way, our attention can turn to the bigger picture. The U.S. federal government debt has ballooned to over one hundred percent of the gross domestic product (GDP), measuring total economic production. According to Strategas, the interest cost on the debt alone has soared to about 17% of tax revenues. These facts do not suggest that the U.S. is in peril of being unable to pay its bills because a dynamic economy and owning the printing press for the global reserve currency provides a robust backstop. The point is that politicians are likely to avoid the painful choices of cutting spending or raising taxes as long as possible. The painless way to exit the situation is by growing the economy at a higher rate, but that path is uncertain. The tried and true strategy throughout history has been to allow inflation to reduce the real cost of the debt since most federal debt is issued with a fixed rate.
U.S. Federal Government Debt
Despite the Federal Reserve’s 2% inflation target, long-term CPI has averaged over 3%. The U.S. has generally enjoyed a tame inflation rate since the mid-1980s, but more recently, the aftermath of COVID and some policy decisions surrounding it has sent the 3-year annualized inflation rate to 5.4%.
Annualized CPI Inflation
Most families strive to retain or, better yet, grow their purchasing power over time. Everyone wants to live as well or better than they are now, but inflation slowly and silently eats away at that goal. The purchasing power of a $100 bill at the end of 1912 would only buy you $3.27 worth of goods today. A more recent example is also startling, with $100 at the end of 2020 worth under $85 in just three short years.
Purchasing Power of $100
On a positive note for investors, yields on U.S. Treasury bonds have risen to reasonable levels. The 10-year Treasury has long-term returned about 2% over inflation to investors. Current yields will be fair compensation if inflation continues to moderate as expected.
U.S. Treasury Nominal Yields
Current real (after-inflation) yields don’t look as good when using the current inflation rate but are far better than the profoundly negative yields in the COVID period.
Real U.S. Treasury Yields
Using the 10-year U.S. TIP as an example, it currently yields 2.11%. So, an investor holding until maturity will earn 2.11% annually over inflation, as measured by the CPI. The implied breakeven inflation rate with a standard 10-year U.S. Treasury can be calculated by taking the nominal bond yield (4.40%) and subtracting the TIPS real yield (2.11%) to get the 2.29%.
10-Year U.S. TIPS Yield: Real & Inflation Components
As one might expect, given the elevated inflation of the last few years, TIPS have outperformed both Treasuries and the Bloomberg Aggregate bond index, which includes other types of bonds, such as corporate debt. Long-term returns from TIPS, even constraining the TIPS maturities to five years or less, stack up nicely against nominal Treasuries.
The choice between short-term TIPS and longer-term is a trade-off between a likely higher potential return from the longer-term versus less volatility and interest-rate risk with short-term TIPS. Since short-term TIPS have a lower duration or interest rate risk, they can provide a more direct hedge against inflation risk.
Annualized Bond Index Total Returns
Implementation of an allocation to TIPS is straightforward. Investors can purchase individual U.S. TIPS bonds or use a pooled vehicle like an exchange-traded fund (ETF) or mutual fund. Short-term TIPS can be targeted with Vanguard’s VTIP or invest in the TIPS universe via iShares’ TIP, and both ETFs track their respective indexes closely.
Like their U.S. Treasury siblings, TIPS are exempt from state and local taxation but are subject to federal income tax. TIPS have an added negative wrinkle with investors taxed on the accreted inflation-adjusted principal value annually despite not receiving that gain until maturity. Due to the added taxation component, owning TIPS in a tax-deferred account is helpful.
TIPS ETFs: Annualized Total Returns
Fed fund futures are now priced at a 68% probability of a rate cut from the Federal Reserve at their September meeting. Almost two whole 25 basis point (0.25%) cuts are expected for 2024. Friday will be another crucial test, with the monthly jobs report typically having a sizable impact on expectations. While odds still favor a continued downward trend for inflation, rate cuts could rekindle the inflation flame.
Probability of a Fed Rate Cut
Treasury inflation-protected securities (TIPS) can provide a powerful addition to most investment portfolios when focusing on purchasing power preservation. While stock ownership in companies that can raise their prices during inflationary periods is the most potent method to increase purchasing power over time, stocks typically have poor short-term performance during inflation shocks. TIPS, relative to stocks and regular bonds, are also likely to thrive during stagflation periods, with high inflation and low economic growth. Using TIPS as part of a diversified portfolio can provide an attractive “safe” asset with no credit risk and income directly tied to inflation.
