Don't Sleep on Inflation: Why TIPS Should Be on Your Radar

And right now, buying inflation insurance could be a big buy.

After watching measures of inflation plunge from highs not seen since the 1980s, many investors have once again started to ignore and sell Treasury inflation-protected securities (TIPS) and their less-exciting cousins, I-bonds. However, this could be the wrong move for the long haul. The sell-off in these asset classes has created some unique buying opportunities, which investors shouldn’t ignore.

The pandemic created one of the most dramatic inflationary environments in a long time. Quarantining, shut-downs, and supply chain woes reduced supplies of a variety of goods and services. At the same time, the sheer amount of stimulus and subsidies flooded the system with money. Low rates made borrowing easy for individuals and corporations. Then when it was over, the snap-back was incredible.

Surging demand was met with the low supplies and we saw a massive surge in inflation. Throughout 2022, the consumer price index (CPI) climbed, reaching a high of 9.1% in June. This was the largest increase since the 1980s.

As such, investors were suddenly very interested in ways to combat the surge in prices. This included a hefty dose of TIPS.

TIPS are sort of a weird bond. Originally created in 1997, they offer a unique way to profit against changes to inflation. Like any bond, TIPS come with a set coupon rate, with an initial rate that is less than a comparable Treasury bond. TIPS will then reset their payouts by resetting their principal values based on changes to the CPI. A $1,000 TIPS with a 1% coupon under a flat CPI would pay $10 in interest. If the CPI jumps by 2%, the TIPS will adjust its principal upward by 2% to reach $1020 and then 1% in coupon against that would be $10.20 in interest. If inflation decreases by 5%, then we would have a principal of $950 and a $9.50 coupon payment.

This all gets complicated since TIPS trade on the secondary market.

This is where things have become a bit disappointing for TIPS investors. As the Federal Reserve has raised rates to combat inflation and slow the economy, TIPS have been hit with a double whammy.

First, as a long bond, they feature a very long duration. The inverse relationship of bonds and interest rates has ensured that TIPS have plunged. Second, the drop in inflation has pushed the principal and coupon payments lower, resulting in poor total return on the investment despite delivering on their promises.

With the declines in TIPS, now could be a good time to strike. A combination of factors could make these inflation-protected assets great for a variety of investors.

For starters, inflation hasn’t gone away. The Fed has done a good job of lowering the CPI from its highs; it’s still sticking around and has been increasing slightly. Moreover, it’s very hard to predict the magnitude and sudden changes in inflation. In fact, according to AllianceBernstein (AB), 82% of the time inflation is often above market expectations by an average of 1.41% higher. This chart from the asset manager shows how badly analysts and investors often miss changes to the CPI. ¹

Source: AllianceBerstein

TIPS have worked well in protecting against these sudden spikes in inflation. Because of this, TIPS have provided excess returns above nominal Treasuries and the broader Bloomberg Aggregate Index.

Then there is the concept of real yield to consider. Real yield is the premium over regular Treasuries that investors get with TIPS. According to AB, investors are well-priced for success. Today, investors can score real yields in the 2.3% to 2.4% range. That’s well above the historic norm and indicates that TIPS offer cheap inflation insurance. Investors have moved on to different pastures.

Today, TIPS are offering cheap inflation protection, both for sudden spikes and long-term increases. As such, investors may want to consider adding them to a portfolio. Doing so is easy.

Individually, investors may want to buy them directly from the Treasury. Here, for a minimum of $100, investors can build out a portfolio of individual TIPS and hold them to maturity. This allows investors to ignore the noise of price changes due to market conditions. They can also create a TIPS of variable maturities to ensure an annual spending amount. The Treasury also sells I-Bonds, which can also be used in concert with TIPS. I-Bonds have their own quirks but have done well in protecting against sudden spikes in inflation. Their current 1.3% fixed rate—which stays with the life of the bond—could be considered a steal.

However, buying individual TIPS does come with a potential headache: taxes. Investors in bonds expect to pay taxes on the interest earned from their bonds. However, investors in TIPS also pay a ‘phantom tax’ on the principal inflation adjustments in the year they occur even though they won’t receive that adjustment until the bond matures.

For investors looking to avoid this phantom tax, there are plenty of ETF options for adding TIPS. Keep in mind that these funds are at the whims of market conditions, investor selling, and changes to interest rates as they roll over their holdings to keep their mandates. But they do offer plenty of protection if inflation suddenly spikes. Investors also have plenty of choices to shorten their durations to reduce interest rate risk.

These funds were selected based on their exposure to Treasury inflation-protected securities (TIPS). They are sorted by their YTD total return, which ranges from -4.3% to 1.3%. They have expenses between 0.03% and 0.20% and assets under management between $500M and $52B. They are currently yielding between 0.2% and 8.9%.

Today, TIPS are offering insurance protection for cheap. Historically, this has been the right time to buy. Investors can get some juicy real yields while still offering protection against sudden spikes in inflation. That makes them a wonderful buy for portfolios. While they may not be exciting, insurance isn’t supposed to be.

After inflation has cooled, TIPS are being ignored by investors. But with strong real yields, the inflation protection is going for dirt cheap. Now could be the best time to lock in that insurance for the long haul.