Lula Tadesse: Treasury Inflation-Protected Securities, or TIPS, help investors shield their assets from inflation. While inflation has been relatively muted in recent years, every investor is exposed to it, and it should be taken into consideration when building a portfolio. In this podcast, we’re going to take a closer look at TIPS—how they work and where they fit in a portfolio.
Welcome to Vanguard’s Investment Commentary podcast series. I’m Lula Tadesse. And in this month’s episode, which we’re recording on March 19, 2019, we have invited Kimberly Stockton, an analyst in Vanguard Investment Strategy Group, to explain to us the role of TIPS in a portfolio.
Kim, thanks for being here today.
Kimberly Stockton: My pleasure.
Lula Tadesse: Kim, let’s start with the basics. Can you briefly explain what TIPS are and provide some historical context—how long they’ve been around and how big a slice of the fixed income market they are.
Kimberly Stockton: Sure. So Treasury Inflation-Protected Securities are just that. They’re Treasuries that are adjusted for inflation. They’ve been around since 1997, and they’ve grown a lot since then. Go back to the year-end 1997, they were only about 1.5% of the U.S. Treasury market. Currently, they’re about 10.0% of the U.S. Treasury market.
Lula Tadesse: What makes TIPS different from other conventional bonds?
Kimberly Stockton: At the most basic level is the risk objectives. If we look at other bonds, other bonds have interest rate risk, they have credit risk, both of which can be diversified. TIPS are the only bond in the U.S. which provide protection from inflation risk.
Another difference is relative to other Treasury bonds. If you consider the yields of other Treasury bonds, other Treasury bonds have a real yield component, and they have an expected inflation component. TIPS, in contrast, have the same real yield component, but they also have an actual component of inflation. So TIPS are less uncertain, a little simpler relative to other Treasury bonds. And as a result, when we look at the history of returns for those different types of bonds, TIPS have been less volatile than other nominal Treasury bonds.
Lula Tadesse: So when you say TIPS are less uncertain, can you explain that?
Kimberly Stockton: Sure. So if we look at those factors that drive the yield and the returns for another Treasury bond, there is this expected inflation component. That’s what the market thinks inflation is going to be. But there is a risk that’s also part of the nominal Treasury bond return that expected inflation won’t be what actual inflation is, right? So there is a risk premium element and a level of uncertainty that we don’t get with TIPS, because TIPS are adjusted for inflation. So we know as an investor in TIPS we’re going to get that inflation protection.
Lula Tadesse: How do TIPS work, because it’s not always clear for many investors?
Kimberly Stockton: Like most other bonds, TIPS have a fixed maturity, and they have a fixed coupon interest rate. But what’s different from other bonds is that TIPS’ principal is adjusted, and it’s adjusted for inflation.
So if you have a TIPS with a principal of $1,000 and you have inflation of 2%, that principal is adjusted to $1,020. That also impacts the coupon payment, because if the principal is higher or lower, then that rate is applied to a different base. That means a different coupon payment for the investor.
Lula Tadesse: Now let’s talk about what may be top of mind for some investors and advisors. Inflation is currently low. So do investors really need to hedge against inflation?
Kimberly Stockton: Yes, you’re right. Our inflation expectations are low. And we look out five to ten years, Vanguard’s expectation for inflation in the U.S. is about 2%. It’s much lower than historical averages since World War II. You’re looking at more like 4%.
So, true, we are in a lower-inflation environment, but there are a number of factors, structural factors that are keeping inflation low—things like technology disruption, aging workforce. Those factors are also keeping interest rates low. They’re also keeping return expectations low. So we’re operating at a lower level, but a lower level across different types of factors. So you have to think about inflation protection relatively.
Another big important point is that we never know when we are going to get an inflation surprise. And inflation surprises, that’s when TIPS really do their job.
Lula Tadesse: Funny you say that because in a recent webcast, Vanguard Global Chief Economist Joe Davis reiterated a similar point. Let’s listen to what he says.
Joe Davis: And despite my fairly high conviction on our inflation outlook, there’s always a risk that it could, at least fears of inflation, could break out. And that’s one of the reasons why you would want to have it as ballast and a diversifier in a portfolio. So, yes, a strategic role I think should be considered.
Lula Tadesse: Joe mentions the possibility of inflation surprises and that we really can never know when these things happen. Can you elaborate on maybe some of the strategic roles that TIPS can play in a portfolio?
Kimberly Stockton: It is the only asset in the U.S. in terms of Treasury bonds that does protect from unexpected inflation, that inflation surprise.
So if we look at TIPS, and we look at their history, not surprisingly, because they’re adjusted for inflation, they’re highly correlated. They move with inflation. They move with expected inflation. But they also move and are highly correlated with unexpected inflation.
And unexpected inflation is really the risk. We talked about the nominal bond yields and the elements of return for other Treasury bonds. They have an expected inflation premium, but we have these surprises. There are many occasions, in fact, a lot of the time actual inflation is different from what was expected, what was built into the nominal Treasury bond. And that’s where TIPS come in. They have a high correlation with the unexpected inflation, and they provide protection from inflation risk.
Lula Tadesse: Now there are different types of TIPS. How should investors and advisors go about selecting one that’s right for them?
Kimberly Stockton: The main difference among TIPS is in their maturity and their duration, which means a difference in their interest rate risk and the volatility in the bond return. So we suggest TIPS for inflation hedging for investors with shorter time horizons. For longer time horizons, we think it’s appropriate for investors to outperform, if you will, inflation. They can invest in riskier assets that have a lot more volatility, but over a long time horizon, those risky assets will and have historically outperformed inflation. So you get inflation protection that way.
But for investors with shorter time horizons, that’s where TIPS can play a role. TIPS, as I mentioned, they’re more highly correlated with inflation and unexpected inflation, and they’re much less volatile than something like global equity.
Lula Tadesse: So, for example, younger investors versus investors that are close to retirement or in retirement, they would get different types of TIPS with different maturities.
Kimberly Stockton: Exactly. Younger investors or any investor with a shorter time horizon—for example, with investors saving for college, we suggest once investors are actually drawing down and paying for college, those investors have a short time horizon, maybe four or five years until their child graduates. During that period, that’s a short time horizon where TIPS can play an inflation-hedging role.
Lula Tadesse: What percentage of an investor’s portfolio should TIPS represent?
Kimberly Stockton: Well, TIPS are like any other asset classes. It’s going to depend on investor risk tolerance, investor time horizon.
Another important consideration is how important an objective is inflation protection for the investor. Some investors may have a highest-return or a total-return objective.
Other investors may value more inflation protection, so there’s a risk/return tradeoff, right? If you invest in something like TIPS that has a higher probability of inflation protection, does a better job there, the tradeoff is some of the return give-up. You aren’t going to see the higher returns that you would see from something like equities.
Lula Tadesse: Some people view TIPS as risk-free assets, perhaps because they’re not as volatile as equities. But are they really risk-free?
Kimberly Stockton: Well, TIPS are government-backed Treasury securities, so the risk of a default is very, very low with them. But there are, of course, other types of risk. We talked a little about the interest rate risks that TIPS have, and different maturities have different interest rate risk. You have longer-maturity TIPS—they have higher interest rate risk— they’re going to be more volatile. So that is one type of risk that is inherent.
In a TIPS return, there are other factors that impact the price of a TIPS bond, and that means TIPS bonds do have some return volatility. So they have risk there. It’s less—less so than, as I mentioned, nominal Treasury bonds, other Treasury bonds, certainly less than equity—but they do have some return volatility to them.
Lula Tadesse: And nothing is ever really risk-free, is it?
Kimberly Stockton: Exactly.
Lula Tadesse: How do TIPS compare with other assets we think of as inflation hedges?
Kimberly Stockton: When we think of inflation-hedging assets, two assets come to mind pretty commonly. We think of cash, for example, so Treasury bills. Treasury bills do have a high correlation. They do move with expected inflation. And that’s probably not surprising. They are also considered a risk-free asset, and inflation expectations are often gauged using Treasury bills. So they have a high correlation with expected inflation, but they actually have a negative correlation with unexpected inflation, so they don’t do a good job of protecting from inflation risk—those inflation surprises.
Commodities, on the other hand— when I’m talking about commodities, we think of broad market Treasury futures indexes—commodities do have a high correlation with unexpected inflation. They also have a high inflation beta, which is just the percentage change in return that comes from a change in inflation. So if inflation goes up by 2%, you have an inflation beta of 5, your return for that particular asset will go up by 10%. So it is a nice feature of an asset, because it can provide inflation protection beyond just the bond portfolio.
The problem with commodities, in our view, is that they’re very volatile. They’re much more volatile than TIPS, and they have historically [had as high as] or even higher volatility than equities. So TIPS are really the best of both worlds. They provide protection from inflation risk, and they do it with low volatility.
Lula Tadesse: That makes sense. How about taxes? Are there tax implications for owning TIPS?
Kimberly Stockton: Yes. TIPS are really well-suited for tax-deferred or tax-advantaged plans like IRAs or 401(k)s because TIPS do have tax implications. And the IRS considers those adjustments that are made to the principal for inflation, the IRS considers any adjustment to principal, as a taxable event.
So investors may not be receiving cash at the time for those principal adjustments, but if they invested in a taxable account, they would need to include those principal adjustments to inflation in their taxable income.
Lula Tadesse: What else would you like to point out about TIPS that would be helpful for investors and advisors?
Kimberly Stockton: TIPS are great for inflation protection, as we’ve discussed, but another aspect of TIPS that investors may not think about is that they are valuable diversifiers. They do have imperfect correlation. They don’t move exactly with other asset classes, other fixed income assets, for example, or even equity. So they can provide a valuable diversification benefit.
Lula Tadesse: That’s a good place to wrap up our conversation. Kim, thanks for sharing your insights with us today and joining us for this Vanguard Investment Commentary podcast.
Kimberly Stockton: My pleasure.
Lula Tadesse: To learn more about Vanguard’s thoughts on the markets, the economy, and other various financial planning topics, be sure to check out our website. Also remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.
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