Given the extraordinary times we are living in, Saxo Bank has decided to make Treasury Inflation-Protected Securities (TIPS) available for trading in the Saxo platform. We believe that inflation is the greatest threat to one's saving and investments. Thus it is crucial to understand how to hedge from inflation risk as underlying inflation expectation continue to rise.
What are Treasury inflation-protected securities (TIPS)?
TIPS are Treasury bonds created to protect investors against inflation risk. They pay a fixed coupon; however, the dollar amount of the interest payment goes up and down according to changes in inflation (CPI Index) as the principal it is adjusted accordingly.
Suppose you own $1,000 in TIPS paying a coupon rate of 1%, at the end of the year you will receive:
- If inflation doesn't rise: $10 coupon.
- If inflation rises by 2%: $10.2 coupon. The principal will rise by 2%; hence the coupon will need to be calculated on a principal of $1,020.
- If inflation falls by 2%: $9.8 coupon. The principal will fall by 2%; hence the coupon will need to be calculated on a principal of $980.
Risks and benefits of holding TIPS
Close to zero market risk
Because the US government issues TIPS, their market risk is close to zero, precisely as Treasury bonds.
Low Inflation and deflation risk
TIPS are indexed for inflation, thus offer low inflation risk. Deflation may cause the price of these securities to fall. However, if held until maturity, TIPS will always return either the inflation-adjusted principal or the par value at maturity of the bond, whatever it is higher. Therefore, there is a natural deflation protection embedded in the structure of the bond.
Liquidity and price fluctuation risk
Other risks of TIPS are price fluctuation and liquidity risk. As a matter of facts, inflation linkers are not as liquid as traditional Treasuries, hence during periods of volatility price may vary significantly. Additionally, the value of TIPS is affected more by expectations in inflation changes rather than the actual movement of inflation.
Market drivers of TIPS prices
The volatility caused by the Covid-19 pandemic this year creates a perfect opportunity to understand what are the main drivers underpinning TIPS' prices.
In March, TIPS yields shot higher as inflation expectations in the short-term fell. This was mainly due to a drop in energy prices and the expectation that social distancing measures would also drive consumer prices lower.