Despite the Federal Reserve’s 2% inflation target, long-run consumer price inflation in the United States has averaged … [+]
Treasury Inflation-Protected Securities (TIPS) share many characteristics with typical U.S. Treasury securities, including semi-annual coupon payments and backed by the full faith and credit of the U.S. government. These bonds differ in that the principal and interest are inflation-adjusted based on the Consumer Price Index (CPI) lagged three months. The value of the principal is adjusted based on inflation, and any increases are paid at maturity. Even in the event of deflation, the value of the principal will never fall below its original face value. TIPS have a fixed coupon rate, but semi-annual interest payments are based on the inflation-adjusted principal.
Now that we know the details of the securities, we can look at the bigger picture. The US federal government debt has ballooned to more than 100% of gross domestic product (GDP), which measures total economic output. Interest costs on the debt alone have soared to about 17% of tax revenue, according to Strategas. These facts do not suggest that the US is in danger of not being able to pay its bills, because a dynamic economy and ownership of the world’s reserve currency printing presses provide a powerful backstop. The point is that politicians are likely to avoid painful choices between cutting spending and raising taxes as long as possible. The painless way out of this situation would be to grow the economy at a faster pace, but the path to doing so is uncertain. A proven strategy throughout history has been to reduce the real cost of the debt through inflation, since most federal debt is issued at fixed interest rates.
U.S. Federal Government Debt
Despite the Federal Reserve’s 2% inflation target, the long-run CPI has averaged over 3%. The US has enjoyed generally benign inflation rates since the mid-1980s, but more recently, the impact of COVID and several related policy decisions has caused the three-year annualized inflation rate to rise to 5.4%.
Annualized CPI Inflation Rate
Most families strive to maintain or even increase their purchasing power over time. Everyone wants to live the same or better than they do now, but inflation slowly and quietly erodes that goal. The purchasing power of a $100 bill at the end of 1912 would buy just $3.27 worth of goods today. A recent example is also astonishing: a $100 bill at the end of 2020 is worth less than $85 in just three years.
Purchasing Power of $100
What’s good for investors is that U.S. Treasury yields have risen to reasonable levels. The 10-year Treasury has offered investors a return of about 2% above inflation over the long term. If inflation continues to moderate as expected, current yields will be a reasonable reward.
U.S. Treasury Nominal Yield
Current real (inflation adjusted) yields don’t look that great using current inflation rates, but they are still much better than the massively negative yields of the COVID period.
Real US Treasury Yields
For example, the 10-year US TIPS currently have a yield of 2.11%. Therefore, an investor who holds to maturity will earn 2.11% per year above the inflation rate as measured by the CPI. The assumed breakeven inflation rate for a standard 10-year US Treasury bond can be calculated as 2.29% by subtracting the real TIPS yield (2.11%) from the nominal bond yield (4.40%).
10-Year U.S. TIPS Yields: Real and Inflation Components
As expected, given rising inflation over the past few years, TIPS have outperformed both U.S. Treasuries and the Bloomberg Aggregate Bond Index, which includes other types of bonds such as corporate bonds. The long-term returns of TIPS compare well to nominal U.S. Treasuries, even when limiting the maturity of TIPS to five years or less.
The choice between short-term and long-term TIPS is a trade-off between the higher potential returns from longer-term TIPS and the lower volatility and interest rate risk of shorter-term TIPS. Because short-term TIPS have lower duration or interest rate risk, they can provide a more direct hedge against inflation risk.
Annualized Bond Index Total Return
Implementing an allocation to TIPS is easy: investors can purchase individual U.S. TIPS bonds or use pooled vehicles such as exchange-traded funds (ETFs) or mutual funds. Short-term TIPS can be targeted with Vanguard’s VTIP or invest in the TIPS universe via iShares’ TIP, both ETFs that closely track their respective indexes.
Like U.S. Treasury bonds, TIPS are exempt from state and local taxes but are subject to federal income tax. A downside to TIPS is that investors are taxed on the inflation-adjusted principal value each year, even though they receive no benefits until maturity. Because of the added tax component, it can be beneficial to hold TIPS in a tax-deferred account.
TIPS ETFs: Annualized Total Return
Federal funds futures currently price the Fed at a 68% chance of cutting interest rates at its September meeting. Nearly two 25 basis point (0.25%) cuts are expected in 2024. Friday will be another key test, as the monthly employment report will have a sizeable impact on expectations. Inflation is expected to continue trending downwards, but a rate cut could reignite the inflation flames.
Chances of Federal Reserve rate cut
If preserving purchasing power is your focus, Treasury Inflation-Protected Securities (TIPS) can provide a powerful addition to most investment portfolios. Owning shares in companies that can increase in price during periods of inflation is the most powerful way to increase purchasing power over the long term, but stocks typically perform poorly in the short term during inflationary shocks. Compared to stocks and regular bonds, TIPS tend to do well in stagflationary periods of high inflation and low economic growth. As part of a diversified portfolio, TIPS can provide an attractive “safe” asset that provides income directly linked to inflation without any credit risk.
