Elevated inflation and Fed downshift: TIPS may do well in this environment
The total return on Treasury inflation-protected securities (TIPS) tends to outperform that of nominal bonds when real yields are falling and the Consumer Price Index for All Urban Consumers (CPI-U) is rising or simply stays at elevated levels higher and more persistently than previously expected.
TIPS are quoted and traded in real yields that can be positive or negative. When the real yield rises, the price of TIPS falls; when the real yield falls, the price of TIPS rises. The most unique feature of TIPS is the principal value varies and is indexed to the CPI-U. The index ratio is calculated by the CPI-U index value published three months before the settlement date divided by the CPI-U index value as of the issuance date of the TIPS. For days during the month, linear interpolation of the monthly CPI-U indices is used. The Treasury Department publishes the updated index ratios for all TIPS issues on its website.
When the CPI-U index value rises, i.e. inflation is positive, the principal value of TIPS will rise by the same percentage. When the CPI-U index value falls, i.e. inflation is negative, the principal value of TIPS will fall. The coupon rate of a TIPS is constant and does not change over the life of the bond. However, the coupon payment will change over time proportional to the change in the principal value. Therefore, the principal and coupon cash flows, that the investor receives, are protected from inflation.
What is not protected is a rise in the real yield of TIPS that reduce the quoted price of the bond. When inflation is positive and even increasingly positive but the real yield is rising fast, the increase in the inflation-indexed principal may not be sufficiently large to offset a decline in bond price and the investor ends up with a loss in total return. From March, the month the Fed started raising rates, to October 2022, the TIPS yield swung dramatically from negative to positive as the Fed raised interest rates aggressively. The 10-year TIPS yield soared from minus-1.0% on March 1, 2022, to positive 1.6% on October 31, 2022, a 2.6% or 260bp movement which caused the 10-year TIPS to fall 21.4% in price. The rise in principal value contributed 5%. The net loss over that eight months was 16.5%. Rising inflation is not enough to generate a positive return for TIPS investors if the Fed aggressively pushes up real interest rates like it did this year. Many investors asked why TIPS lost money in most of 2022 through October and the 260bps rise in the real yield is the answer.
The investment environment has become more favorable for TIPS since November 2022 when the Fed signaled to the market that it will downshift the tightening pace even before inflation falls substantially.
In Figure 8, the green, light blue, and dark blue lines are breakeven inflation rates implied by the difference between yields on nominal Treasury note yields and the yields on TIPS, which are real yields. The bond market is pricing in future inflation at very near to the Fed’s 2% target as investors believe that the Fed will be able to bring down inflation towards 2%. In a combination of stubbornly high inflation and the Fed’s downshift in the pace of tightening, the line of least resistance for breakeven inflation is going upward, approaching the elevated actual inflation and away from 2% rather than falling below 2%.