Treasury Inflation-Protected Securities (TIPS) what they are an how to trade them.

Bonds

Althea Spinozzi

Fixed Income Strategist, Saxo

Summary:  As inflation expectations continue to rise, it is crucial to understand how to hedge against it. In this page, we look at Treasury Inflation-Protected Securities (TIPS) and explain what they are and what are the risks involved in trading with them.


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:

  1. If inflation doesn't rise: $10 coupon.
  2. 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.
  3. 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.

Inflation expectations

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.

Lower inflation expectations also provoked an inversion of the TIPS yield curve in March (in yellow). However, as the economy reopens and activities resume, we see the US TIPS yield curve normalizing (in green).

Source: Bloomberg.

Looking ahead, inflation expectations are rising, underpinning more upside for TIPS. In particular, expected inflation in the next three years ahead rose faster than the expected inflation for the next 5 to 10 years.

US Federal Reserve bond-buying programme pushes TIPS prices higher

As of March, the prices of TIPS have risen considerably pushing their average yield to the lowest point since Bloomberg Barclays index started to track it in 1997. TIPS’ negative yields may discourage investors; however, the reason why TIPS have rallied significantly is because of the Federal Reserve bond-buying program. As per Bloomberg data, since March, the FED has doubled its holding of TIPS.

At the same time, TIPS issuance has slowed down since 2013 until today, stabilizing the share of TIPS over Treasuries (excluding T-bills and floating-rate notes) in the market since the beginning of 2018. Therefore, with the FED increasing the holding of these instruments if inflation expectation unexpectedly rises, there might not be enough offer to satisfy TIPS demand while investors change Treasuries for inflation linkers.

Why buying TIPS gives better protection against inflation compared to gold?

Compared to TIPS, gold is not an isolated inflation play. Gold is sensitive to risk appetite, to the value of the USD, and it is also used as a geopolitical instrument. Gold doesn't pay dividends, but it might give comfort to investors that are afraid about a possible default of the issuer.

TIPS, on the other hand, are a good diversification instrument because they do not correlate with fixed income or equity products. Additionally, the price inflation protection built-in pays a steady cashflow.

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