Most Popular ArticlesAugust 4, 2009
TIPS have been a good hedge against the equity markets
The graph below plots the betas of real, nominal, and breakeven returns against the US equity market. (Beta is a measure of systematic risk – risk which cannot be diversified away. It is determined by a statistical regression procedure.)
Betas of TIPS (the 10-year real bond beta) have been predominantly negative over the last decade, implying that they are a good hedge against the systematic risks of the US equity market. The same is true of nominal bonds.
Implications for advisors
TIPS are the safest way to protect against inflation, and they are arguably the safest investment in the market, assuming one holds individual TIPS bonds to maturity. Investors who need liquidity before maturity face additional risks, as the authors outline in their study. TIPS funds present additional risks, which we highlighted in a previous article.
If you are dead-set against TIPS, you can try to hedge against inflation by rolling over Treasury bills at a short interval, perhaps monthly. This strategy offers inflation protection provided that real interest rates are stable but, as we saw during 2008, such is not always the case.
The authors also note that if central bankers are able to establish an environment where inflation expectations are stable (and the breakeven rate is constant), then nominal bonds will offer the same inflation protection as TIPS. But such a “nirvana” seems highly unlikely.
One risk the authors do not address is that TIPS returns are dependent on the government’s calculation of inflation through the CPI-U rate. The government has changed its methodology for these calculations a number of times in the past, most notably during the Clinton administration. Some, including John Williams of Shadow Government Statistics, argue that the government’s incentive to keep down the costs of entitlement programs such as Social Security motivated these changes to the CPI calculations. Nonetheless, while institutional investors may be able to employ superior inflation-hedging vehicles like swaps, TIPS remain the best inflation hedge for retail investors.
One of the most interesting findings in this study concerns the diversification value of TIPS. The authors studied the behavior of a portfolio composed of US stocks, nominal 5-year Treasury bonds, and 3-month Treasury bills. They examined data from 1953 to 2008, segmenting their analysis to pre- and post-1973, since the process for fighting inflation changed in the seventies.
By adding TIPS to their hypothetical portfolio, they were able to reduce substantially risk (volatility) for long-term investors. Moreover, the reduction in risk is greatest when TIPS prices are most volatile. Their explanation for that paradoxical result is that “it follows directly from the fact that inflation-indexed bonds are needed for long-term safety when real interest rates vary persistently over time.”
Investors should not be deterred by the argument that TIPS are unattractive because the market may be illiquid. TIPS may be less liquid than the highly liquid nominal bond market, but long-term buy-and-hold investors will incur very little in the way of transaction costs, so liquidity should not be a concern.
“Low inflation-indexed yields and high short-term volatility of inflation-indexed bond returns do not invalidate the basic case for these bonds,” the authors conclude. “They provide a safe asset for long-term investors.”
TIPS have surged in popularity this year among advisors. The Vanguard Inflation Protected Securities fund (VAIPX) now ranks as the sixth most popular fund in the Advisor Perspectives universe, up from 19th at the start of this year. This universe consists of approximately $50 billion in high- and ultra-high net worth assets managed by investment advisors.
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