Last month’s five-year Treasury Inflation Protected Securities (TIPS) auction drew nearly $48 billion in interest, a sign of recent renewed demand for this inflation indexed asset class among investors. TIPS can be an intriguing way to get exposure to Treasuries in today’s interest rate environment. With the recent rise in interest rates, and the continued low level of expected inflation, TIPS may provide an interesting opportunity. And, as my colleagues stress in a recent paper, it can make sense for some investors to buy inflation protection before they actually need it.
Inflation, duration and TIPS
Most U.S. Treasury securities have two sources of return: coupon and price. Coupon payments are paid semi-annually. The price of the security fluctuates with changes in market yields. TIPS securities have three sources of return. Like other Treasuries, they pay a coupon and their price will be impacted by changes in yields. Additionally, a holder of a TIPS bond is impacted by inflation; if inflation rises the holder could receive both higher income and a higher principal payment at maturity (although it should be noted that TIPS typically have lower yields than conventional fixed rate bonds). If inflation falls, income will likely decline, as would the principal payment at maturity (though you can never get back less than the original par value at which the bond was issued). TIPS are one of the few asset classes that directly pays an investor for realized inflation, making them attractive during periods of rising inflation. This compensation is the same for all TIPS securities. For this reason, investors who believe interest rates might fall often prefer longer maturity TIPS, while those who believe that rates will rise may want shorter maturity TIPS.
External factors driving demand for an inflation-hedged approach
The recent uptick in oil prices, coupled with the stabilization of consumer prices, have pushed the market price for expected inflation higher. You can see our comparison of several key inflation measures, including the two-year “breakeven inflation rate”, the Consumer Price Index (CPI) and the CPI excluding food and energy, in the chart below.
The “breakeven inflation” rate is the rate of inflation that the market believes will be experienced over the next two years. The CPI measures the change in prices for a basket of goods purchased by consumers. CPI excluding food and energy is this same basket with the food and energy components removed.
While we aren’t worried about inflation at this very moment, we expect that interest rates will rise at some point later this year. And if the Fed is successful in goal of increasing inflation, then we could see inflation measures like CPI rise as well. For investors who are concerned about potential inflation, TIPS may be a good solution.