Inflation has skyrocketed this year.
In fact, inflation jumped to a 40-year high of 8.5% in March 2022.
So why are Treasury Inflation-Protected Securities (TIPS) losing money?
What are TIPS exactly?
And do they belong in a retirement portfolio?
If you want answers to these questions, you’re going to love today’s episode.
How to Listen to Today’s Episode
- Stay Wealthy Inflation Series:
- David Swensen:
- Survey of Professional Forecasters [Federal Reserve Bank of Philadelphia]
- US Inflation Calculator
- Residual Inflation Risk [SSRN]
- Asset Allocation with Inflation-Protected Bonds [SSRN]
- Diversification Benefits of TIPS [SSRN]
Why Are TIPS (Inflation-Protected Bonds) Losing Money?
Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and, as we all know, inflation has skyrocketed this year.
In fact, inflation jumped to a 40-year high of 8.5% just two months ago.
So, why then, are TIPS (aka. Treasury Inflation-Protected Securities) losing money?
And what are TIPS exactly? Do they belong in a retirement portfolio?
If you want answers to these questions, you’re going to love today’s episode.
For all the links and resources mentioned today, head over to youstaywealthy.com/154.
The Consumer Price Index report (aka the monthly inflation report) for the month of May 2022 is scheduled to be released tomorrow.
As a reminder, these reports come out monthly. Tomorrow, on June 10th, we’re going to be given the inflation data for last month, the month of May. But the headlines that most will see reflect the annual inflation rate, measuring the 12-month time period from May of 2021 to May of 2022. In other words, the annual inflation rate is backward looking.
For example, the April CPI report indicated that inflation was 0.3%, or said more accurately, that the consumer price index increased by 0.3%. But the annual inflation number, the 12-month number measuring April 2021 to April 2022 was 8.3%. And that 8.3% number is, again, what most of us saw in the news. Because let’s be honest, a headline stating that prices jumped 0.3% wouldn’t generate the necessary clicks and eyeballs needed to generate meaningful advertising revenue.
Anyhow, it’s possible that tomorrow's inflation report, announcing the Consumer Price Index change for the month of May will reveal a lower annual inflation number. Instead of 8.3%, maybe we see something closer to 8% or 7.9%. I’m not sure and I haven’t seen any intelligent forecasts that are worth sharing here.
But again, since the annual inflation number that will make headlines is backward looking across the previous 12 months, it will be most interesting to isolate and look at the data for the month of May to get a better sense of the current change in consumer prices across the different categories. I’ll be sharing these details and my thoughts next Tuesday, so be sure to tune in.
But even if we do see a positive report tomorrow and inflation drops a bit, it doesn’t necessarily mean the trend will continue.
Things like the Ukraine war, china shutting down, and surging commodity prices could cause more inflation in the very near future.
On the other hand, rising interest rates, a cooling off in the housing market, fiscal tightening, and a recession looking more and more likely could push inflation lower.
While we don’t know what inflation will do in the future, we know what it’s done in the past.
We kicked off 2022 with a January CPI report indicating a 7% year-over-year change in prices. In February, inflation jumped to 7.9%, and in March, inflation reached a 4-decade high of 8.5%.
So, why then, are TIPS (aka treasury inflation-protected bonds) down approximately 6% this year if we’re experiencing inflation spikes that haven’t been seen in 40 years?
To answer that question, we have to first understand what TIPS are exactly. Because I think the name can be a bit misleading or, at the very least, cause confusion.
And I don’t blame anyone for being confused. Here’s the definition straight from the US treasury website:
“TIPS provide protection against inflation. The principal of increases with inflation and decreases with deflation, as measured by the Consumer Price Index or CPI.”
But, as investors have learned this year, it’s not quite that simple. CPI is up, TIPS are down. So let’s dig in to better understand why this is.
To start, like your traditional U.S. treasury bonds, TIPS are issued by the U.S. government, and therefore are AAA-rated securities, the safest bonds you can own.
But unlike traditional U.S. treasury bonds (also referred to as nominal bonds), TIPS are adjusted for inflation, causing interest payments to vary.
While interest payments can and do fluctuate, the actual interest rate on TIPS is FIXED. But the fixed rate is applied to the value of the bond, and the value of the bond changes and adjusts to inflation.
So if the principal value of the bond goes up due to rising prices, investors will receive a higher coupon payment. 5% x a principal amount of $1,100 is higher than 5% x $1,000. The interest rate didn’t change, but the value of the bond did, which causes the interest payment to the investor to change.
Another important thing to know is that TIPS can be purchased with 5, 10, or 30-year maturities. And when the bond matures, the investor will receive the higher of the adjusted principal amount or the original principal, in addition to the interest earned along the way of course.
You can also buy TIPS through a mutual fund or exchange-traded fund which is typically the desired solution for most retirement investors.
To summarize, TIPS are US government bonds that deliver after-inflation returns (aka “real returns) whereas conventional US treasury bonds (aka nominal bonds) provide returns before inflation. That difference is the primary reason why TIPS usually pay lower interest rates than nominal bonds.
So, with all of this in mind, if you have a crystal ball, you would want to buy TIPS when you think inflation will be ABOVE market expectations in future months and years and buy nominal US treasury bonds when you think inflation will be BELOW future expectations.
I’ll say that again because it’s the most important piece to answering today's question.
If you have a crystal ball, you would want to buy TIPS when you expect inflation to be ABOVE market expectations in future months and years and buy nominal US treasury bonds when you expect inflation to be BELOW future expectations.
And there is accessible data for investors to get an aggregate view of future expected inflation, allowing investors to put their crystal ball to the test if interested. One such data set would be accessed through the Survey of Professional Forecasters published by the Federal Reserve Bank of Philadelphia which I’ll link to in the show notes.
As noted by ETF.com,
“the survey of professional forecasters includes more than 50 economists from many of the leading financial and research institutions in the country. Their views help shape opinions about expectations for inflation.”
Another method for determining if TIPS make more sense than nominal bonds is what is known as the 5-year inflation swap. I’ll spare the nerdy details and link to a few academic papers in the show notes if you want to dig in.
In addition not putting you to sleep, the main reason for not getting into the weeds on this methodology is that, no matter what way you spin it, we’re making a prediction and an active market timing decision to choose TIPS over nominal bonds.
Sometimes your prediction may be right and other times it may be wrong. Which is primarily why the late David Swensen, Yale’s long-time CIO who revolutionized endowment investing, advocated for cutting your allocation right down the middle – owning 50% TIPS and 50% nominal US treasury bonds in the bond sleeve of your portfolio. So if you have a 60/40 stock/bond portfolio, 20% would be in US treasury bonds and 20% would be in TIPS.
I’ve mentioned it before on the show, but Swensen's book, Unconventional Success, is one of my all-time favorite investing books. And in the book he lays this philosophy out in more detail. But you can also just quickly Google “The Swensen Portfolio” to see a quick breakdown of his model.
So, why are TIPS losing money this year? In summary, because the current environment has been in line with market expectations.
In addition to driving home the point that knowing when to buy TIPS vs nominal bonds is pretty much impossible, I also want to highlight that, like all bonds, TIPS contain risk. They can be a smart addition to bond portfolios, but they are not risk-free as some get trapped into thinking. They are impacted by changes in interest rates and actions taken by the federal reserve.
It’s important to understand the risks and set proper expectations with this asset class (or any asset class for that matter) before investing your hard-earned money. And with an enticing name and deceptive definition, it is easy and common for people to have the wrong expectations when investing in TIPS.
Lastly, one final fun fact to take into consideration here is that TIPS are actually a relatively new asset class. They were first auctioned in January 1997, so we only have about 25 years worth of data, compared to 100 years of data for most other major asset classes. For that reason, some argue that we may need more data to determine, with certainty, the role that TIPS play in our retirement portfolios.
Once again, the show notes for today's episode can be found by going to youstaywealthy.com/154.
Thank you as always for listening and I’ll see you back here next Tuesday where we will dissect the May inflation report and attempt to make some thoughtful and informed observations for the year ahead.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.