One critical component of the marginally positive total returns in prior years when real yields rose was the income cushion that helped to mitigate the impact of price declines. For example, Figure 3 shows that for most of TIPS’ history through June 30, 2012, investors collected a real yield of at least 2%. Today, however, that yield cushion is gone, negating the mitigating impact on price volatility.
Figure 3: Real yields today don’t provide the same income cushion
Note: Historical real yields represented by Barclays U.S. TIPS Index from February 28, 1997, through June 30, 2012.
Sources: Vanguard and Barclays.
In addition, today’s very low real yields influence the sensitivity of TIPS to real interest rate movements. Duration plays a key role in the volatility of TIPS as well as nominal bonds. The longer the duration of a bond portfolio, the greater the sensitivity to changes in yields.
Figure 4 highlights the fact that the historical average duration (real) for the broad TIPS market has been about 8 to 9 years, which is where it is today. This duration falls between the durations of the Barclays 5–10 Year Treasury Bond Index and the Barclays U.S. Long Treasury Bond Index.+ However, historically, the broad TIPS market has experienced volatility similar to that of the Barclays 5–10 Year Treasury Bond Index. The similar average volatility, despite the slightly longer duration for the TIPS benchmark, is due to the fact that changes in real yields, which affect TIPS, are less volatile than changes in nominal yields, which affect nominal bonds.++ These volatility data further underscore that TIPS can be risky, and especially so with today’s razor-thin (or negative) real yields contributing to higher durations.
Figure 4: Duration and standard deviation of Treasury securities: March 1997–June 2012
Notes: Benchmarks used were the Barclays 1–5 Year Treasury Bond Index, the Barclays 5–10 Year Treasury Bond Index, the Barclays U.S. Government Inflation-Linked All Maturities Bond Index, and the Barclays U.S. Long Treasury Bond Index. Standard deviation is annualized.
The Barclays U.S. Government Inflation-Linked All Maturities Bond Index data reflect real duration because TIPS volatility is affected by moves in real interest rates. However, data for the Barclays 1–5 Year Treasury, 5–10 Year Treasury, and Long Treasury Bond Indexes are nominal duration (non-inflation-adjusted) because nominal bonds’ volatility is influenced by changes in nominal interest rates (non-inflation-adjusted).
Sources: Vanguard and Barclays.
Conclusion
Like conventional Treasury bonds, TIPS can decline in value over any short-term period. In other words, investors should not view a TIPS portfolio as a risk-free inflation hedge. Considering that the best long-term predictor of bond returns is the starting yield, with TIPS real yields near zero today, the long-term expected real return of TIPS would also be near zero. From a nominal return standpoint, if current break-even rates of inflation between 10-year TIPS and 10-year nominal Treasuries are about 2%–2.5%, adding that inflation expectation to the zero real-return expectation puts the long-term expected nominal return of TIPS at 2%–2.5%, unless there is a significant upward or downward movement in inflation. Those expectations are much lower than past returns.
Investors should consider TIPS as a long-term investment to mitigate the impacts of unexpected and high inflation. As with most investments, the short-term performance of TIPS, both positive and negative, is an unreliable basis for long-term return expectations. Given the current low-yield environment, the return outlook for TIPS (as with most U.S. bond investments today) is muted and likely to be more volatile than in the past. Nevertheless, the strategic case for bond diversification remains strong—including that for TIPS—given the uncertainty of the future inflation outlook.
* An investor who holds an individual TIPS to maturity is more truly inflation-hedged for that specific time horizon than a TIPS fund investor for the same period. This is because of the real interest rate risk associated with the fund, which does not pay inflation-adjusted principal back on a set maturity date.
** Break-even inflation is the difference between the yields of a nominal Treasury bond and a similar-maturity TIPS bond. The BEI rate represents not only the bond market’s expectation of future inflation over the life (or maturity) of the bonds but also risk premiums that reflect the uncertainty about future inflation and the relative liquidity of the two bonds.
+ The real duration of the TIPS benchmark is higher than that of the Barclays 5–10 Year Treasury Bond Index because the Barclays U.S. Government Inflation-Linked All Maturities Bond Index contains securities that have a broad range of maturities, including some that are much longer.
++ The average volatility of monthly real yields, represented by a constant-maturity 10-year U.S. TIPS bond, was lower than the average volatility of monthly nominal yields, represented by a constant-maturity 10-year U.S. Treasury nominal bond, from January 2003 through May 2012.
References:
- Bennyhoff, Donald G., 2009. Preserving a Portfolio’s Real Value: Is There an Optimal Strategy? Valley Forge, Pa.: The Vanguard Group.
- Campbell, John Y., Robert J. Shiller, and Luis M. Viceira, 2009. Understanding Inflation-Indexed Bond Markets, NBER Working Paper No. 15014. Cambridge, Mass.: National Bureau of Economic Research.
- Dektar, Daniel C., 2005. ABCs of TIPS. CFA Institute Conference Proceedings. Fixed-Income Tools for Enhancing Returns and Meeting Client Objectives (February): 43–51.
- Hammond, P. Brett, 2002. Understanding and Using Inflation Bonds. TIAA-CREF Institute, No. 73 (September); available at www.tiaa-crefinstitute.org.
- Vanguard Group, The. Investing in Treasury Inflation Protected Securities, 2006. Valley Forge, Pa.: The Vanguard Group.
- Wallick, Daniel W., and Jill Marshall, 2009. TIPS and the Nature of Inflation Protection. Research Note. Valley Forge, Pa.: The Vanguard Group
Notes:
- All investments are subject to risk, including the possible loss of principal.
- Past performance is no guarantee of future returns.
- Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
- While U.S. Treasury or government-agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
- Diversification does not ensure a profit or protect against a loss in a declining market.
- The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.