An episode from Vanguard’s Investment Commentary podcast series

The prospect of rising inflation can be worrisome to your clients, especially those who are in retirement. One way to address that concern is by using Treasury Inflation-Protected Securities (TIPS), which provide an explicit hedge against inflation.

In this 13-minute podcast, Daren Roberts, an analyst in Vanguard Investment Strategy Group, discusses the types of TIPS products available, their risks and benefits, and the types of investors they may be suited for.

Note:

  • All investing is subject to risk, including the possible loss of the money you invest.

TRANSCRIPT

Jim Nelson: When inflation starts to heat up, investors may start to think about including Treasury Inflation-Protected Securities, or TIPS for short, in their portfolios. But how much of a hedge against inflation do these investments really provide?

I’m Jim Nelson, and welcome to Vanguard’s Investment Commentary Podcast series. In this month’s episode, which we’re recording on March 23, 2017, we’ll look at the role of including TIPS in a portfolio.

We’re joined today by Daren Roberts, an investment analyst in Vanguard Investment Strategy Group. Thanks for joining us today, Daren.

Daren Roberts: Thank you.

Jim Nelson: In a nutshell, Daren, how do TIPS compare to conventional bonds?

Daren Roberts: Conventional bonds, maybe you can use nominal Treasuries as an example, they pay a stated yield, they’re unadjusted for inflation. Whereas TIPS, or Treasury Inflation- Protected Securities, those bonds are adjusted for inflation in specifically the Consumer Price Index (CPI). So changes in those baskets of goods, which are underlying in the CPI, those changes get embedded in your TIPS principal and coupon payments.

Jim Nelson: So how exactly does that work?

Daren Roberts: Well, for example, if you have say a TIPS security say $1,000 par amount, and let’s say the change in CPI is around 5%, well your par, or your principal, will go from $1,000 to $1,050, and the coupon will be adjusted accordingly as well. But I think the good news is that you have a security that’s designed to keep pace with inflation and also to maintain your purchasing power.

Jim Nelson: And what if inflation went negative, how would that affect TIPS?

Daren Roberts: Well, you have an adjustment based on the change in CPI, so that change could be positive or negative. I think the way the security is structured is that there’s a floor, so the change in CPI, even though there’s an adjustment to your principal, it won’t fall below the par amount.

Jim Nelson: And I know there are different kinds of TIPS. What’s the difference between short-term TIPS and the broader market TIPS?

Daren Roberts: Sure. Short-term TIPS is a slice of the broader TIPS market, and the short-term TIPS is really defined by the maturity. So it’s under 5 years in maturity. It’s also a fairly deep market. It’s about 40%, give or take, of the broader TIPS market.

The other thing to consider is also duration, which is really just how much the change in price is affected by the change in yield. And the other thing to consider is that because it’s a shorter-maturity bond, it has a shorter duration as well.

Jim Nelson: So why would someone opt for short-term TIPS?

Daren Roberts: Well, it depends on the strategy. So what we’ve found, again, is that short-term TIPS has a higher correlation to changes in CPI or inflation. And if your objective is to match your assets and your liabilities, or the liabilities are indexed to inflation, we found that TIPS serves as a better vehicle because your return component is more driven by the change in CPI versus changes in interest rate sensitivity, which you would find with the longer TIPS vehicle.

Now with broader TIPS, you’re getting higher volatility, but you’re also getting higher expected income. But then counter to that is you’re getting a vehicle that is probably less correlated— relative to short-term TIPS—to inflation or CPI.

Jim Nelson: So TIPS provide explicit protection against inflation. So what are the advantages of using them? And then we’ll get into risk a little bit later.

Daren Roberts: Sure. Well, I mean one of the advantages is TIPS provide, as I mentioned earlier, an adjustment to unexpected changes in inflation. I think the risk, it really comes down to how it’s applied. And I think much like conventional bonds, it’s not risk-free, so you can lose money. And then also in a balanced portfolio, it minimizes the effects of inflation, but it’s not a full hedge unless you have like a 100% TIPS portfolio.

And the other thing to consider is that if you have liabilities that are growing different than that in the change in inflation—so, again, we’re using CPI as that measure—using TIPS may not be the most effective strategy because if you’re trying to match your assets with your liabilities, you might find that your liabilities are growing faster than your assets, and so you’re in some ways mismatched.

Jim Nelson: For older people who maybe aren’t working, are TIPS a good idea to have in their portfolio because it does provide some protection against inflation?

Daren Roberts: I think so. An investor who’s in retirement, their objectives and their needs are very different than someone who is just starting in the workplace. And for a retiree, in most cases they’re concerned more about capital preservation and maintaining spending power. And so having a security that helps to adjust for that, whether it be in the short term, can be very effective in maintaining that portfolio.

Jim Nelson: Now, are TIPS good to protect against unexpected hikes in inflation? If suddenly everything starts heating up, do TIPS somehow compensate for that?

Daren Roberts: Well it depends on the vehicle; but if we’re talking about CPI, yes it does. I mean that’s the intended point of it being adjusted for inflation. So TIPS gives you that baked-in protection. It is, in fact, an inflation hedge. I think I should also qualify that there are other alternatives that are used as a proxy for an inflation hedge. And we looked at, in terms of our research, gold, commodity futures, real estate, or proxies for real estate such as REITS.

And our research has shown that, again, if you’re talking about sort of short-term changes in inflation, we’ve found that short-term TIPS is a better vehicle relative to those other securities. And, quite frankly, you also have to take a look at the volatility of those assets as well, which can be a risk factor, as well as the cost of using those instruments.

Jim Nelson: So inflation has been low it seems like for years. Should investors still have TIPS in their portfolio when inflation levels are low?

Daren Roberts: Well, I think this is more a backdrop of low yields in general. So this isn’t just related to TIPS. We are just seeing a low-return environment, and that’s the stocks, that’s general, sort of high-quality bonds. And some of that has to do with structural issues in the economy. And I just think that’s important to point out. But nonetheless, I think you still have to take into account the role of bonds, and it’s not purely just a return vehicle. It is sort of a diversifier against your stock volatility.

Jim Nelson: So why shouldn’t short-term TIPS, because they do have that lower duration, be considered a cash substitute?

Daren Roberts: Well, we just found, based on our research, that it’s not a good proxy for cash because if you look at the correlations between short-term TIPS returns and cash—and we’ve looked at this over a 10-year period—that correlation is closer to zero.

Jim Nelson: So which types of investors would TIPS be most suited for?

Daren Roberts: Well we feel that TIPS are well-suited for tax-deferred or tax-advantaged investors. And those would be described as 401(k) investors or IRA investors, as well as investors seeking a real return to fund a spending program where the principal and the purchasing power needs to be preserved.

I highlight those investors specifically because there can be tax implications for investors based on where the TIPS reside in their portfolio. So, for instance, if TIPS sit within a taxable account, the inflation adjustment and the coupon payments can be subjected as taxable income by the IRS.

Now one practical example of how Vanguard utilizes short-term TIPS broadly speaking is in our Vanguard Target Retirement Funds. Now we don’t utilize short-term TIPS throughout the entire glide path because the needs and objectives across an investor’s life cycle are very different. So a person entering the workforce defaulted into, say, a Target Retirement Fund 2050 would have a higher allocation toward stocks because their wealth is really tied up in human capital and the potential for future earnings. Whereas someone who is nearing retirement, their wealth is more tied up in financial savings. And their risks are more toward the balance of inflation risk, market risk, and also longevity risk. So that investor would actually need to shift away from stocks, and that’s why we introduce more fixed income like TIPS to offset the lack of future capital.

Jim Nelson: So when you’re like me and you have more time behind you than maybe in front of you, maybe you want to think about TIPS?

Daren Roberts: Right. I mean it’s more about, again, reducing market risk in your portfolio and lessening the volatility aspect to being prepared for retirement.

Jim Nelson: Now how long have TIPS been around?

Daren Roberts: Yeah, they’re about 20 years old, I think, within the U.S. There are inflation-protected securities outside of the U.S., so it’s not just a U.S. phenomenon. They’re called by different names, obviously. They’re real return bonds in Canada. They’re [Japanese] linkers. But they have been around, and they serve a very important purpose in clients using them to have an inflation hedge or a proxy for an inflation hedge.

Jim Nelson: Now does the idea of TIPS being overpriced or underpriced, should that factor into any investors’ decisions about whether to get into them?

Daren Roberts: Well, technically speaking, that’s very difficult to try to anticipate. I think our implementation with respect to TIPS is more strategic.

Now if you do have a view or you do have an investor preference, we do accommodate for that as well. We do have a short-term TIPS product, which is index-based. We do have an active strategy with TIPS as well. But we do caution investors to think about the implementation because, again, it’s not a risk-free investment. And you should be thinking more about your goals and how using certain tools to help you maintain that objective and really think about it in terms of a long-term view.

Jim Nelson: Daren, do you have any final thoughts for investors and advisors as they think about TIPS?

Daren Roberts: Sure. TIPS can serve as an effective tool in a diversified portfolio strategy where an investor wants to minimize some exposure to inflation, keeping a capital-preservation mindset.

I think it’s also important to know that TIPS can also, much like conventional bonds, lose money over a short-term period. So it’s just a helpful reminder to know it’s not a risk-free investment.

Jim Nelson: Well, that seems like a great place to end the conversation. Daren, thanks so much for being with us today.

Daren Roberts: Thank you.

Jim Nelson: And we hope you’ve enjoyed this Vanguard Investment Commentary Podcast. Be sure to check back with us each month for more insights on the markets and investing. And, remember, you can always follow us on Twitter and LinkedIn or visit our website at any time. Thanks for listening.

Notes:
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Investments in bonds are subject to interest rate, credit, and inflation risk. Although the income from U.S. Treasury obligations held in the fund is subject to federal income tax, some or all of that income may be exempt from state and local taxes. Diversification does not ensure a profit or protect against a loss.
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