Loans, TIPS, Inflation, and the Fed

A version of this article was originally published in the April 2018 issue of Morningstar FundInvestor.

The Treasury Inflation-Protected Securities and bank-loan sectors are notable for their sensitivity to interest rates and the economy, but that's about as much alike as they're ever likely to be.

Yields among the kind of leveraged bank loans usually found in mutual funds are tightly linked to short-term rates, and interest-rate futures recently signaled that the market is expecting the Federal Reserve to raise its key federal-funds rate to between at least 2.00% and 2.50% by the end of 2018, with modest probability baked in that they could get as high as 2.75% or more.

Happy Loan Days Are Here Again In general, that's good news for investors in bank-loan funds, given that leveraged loan rates are typically set at a specified level above three-month Libor (which usually trends closely with the federal-funds rate) and reset periodically. So, for example, if Libor goes up, a bank loan's payout will normally go up along with it. And unlike conventional fixed-rate bonds, whose prices are generally driven down when market yields go up, bank-loan prices usually don't respond much because investors expect their rates to catch up quickly as their loan rates reset.

You can see that in the experience of

For Now ... There is a caveat, but one that applies to longer time frames. In most cases, short-term rates are driven up in response to healthy economic conditions, which is usually good news for bank-loan issuers. As long as their businesses continue to thrive, the need to pay out larger sums as their loan rates rise may not be a problem. When economic weakness and high bank-loan rates converge, though, the combination can hurt the creditworthiness of borrowers and threaten loan prices.

Don't Get an Inflated Sense of Your TIPS

The story is a little different for TIPS. Although the amount that the U.S. Treasury agrees to pay a TIPS investor at maturity is periodically adjusted in step with inflation, it usually moves in small increments from year to year. TIPS yields (and thus their prices) are generally very sensitive to changes in those of comparable plain-vanilla Treasuries, though, and the average maturity of

That's notable because bond investors can sometimes react forcefully to Fed actions. The market has been progressively anticipating the Fed's moves, and Treasury notes have reflected it. The 10-year Treasury yield began a rising cycle around the end of 2017, moving up roughly 60 basis points through April 27, 2018, and taking a 1.3% bite out of Vanguard Inflation-Protected Securities during that stretch.

Reports of the Bond Market's Demise May Be Greatly Exaggerated Fortunately, there isn't any broad expectation that longer-term Treasury yields are set to go up exceedingly fast or all that much more as a result of inflation or the Fed's next hikes. In fact, despite occasional pundit worry that long yields are on the brink of soaring, market prices in late April implied that 10-year Treasury yields would be only 0.10% to 0.15% higher five years hence. Of course, market expectations are just that, and TIPS can certainly be even more volatile from month to month, so it's still worth making sure that you can stomach the pain if the market reacts differently.