Why TIPS Look Attractive

Treasury Inflation-Protected Securities

Tuesday’s column laid the table for today’s discussion by outlining how Treasury Inflation-Protected Securities are built and priced. This article expands upon that work by revealing why many financial professionals now favor TIPS.

For buy-and-hold investors, TIPS are the surest possible choice, although they do not appear that way on the surface. Whereas both the yields and redemption values of conventional bonds are fixed, those of TIPS are variable. We cannot know at this moment what income TIPS will generate next year, nor can we forecast what the Treasury Department will pay to reacquire the investment when it matures.

The uncertainty is illusory, a product of thinking in nominal terms about goods and services that have real prices. Conventional bonds make payments that have uncertain purchasing power, while TIPS guarantee that, after adjusting for inflation, investors will receive exactly the dollars that they are promised, along with their original capital upon the maturity date. In truth, TIPS are the safe bet.

Current Yields

This means that although TIPS can perform erratically in the secondary market, causing headaches for those who must sell early, their value for buy-and-hold investors can easily be determined. Their yields tell all. Higher is better. Unlike traditional bonds, there is no need to hedge that statement with caveats about how future inflation might behave. The analysis is that simple.

And yields are currently generous. Earlier this month, the interest rate on 30-year TIPS exceeded 2% for the first time since 2011.

Historic Yields: 30-Year TIPS

(August 2004-Sept. 13, 2023)

(Note: Technically, this chart combines the record of 20-year TIPS yields with that of 30-year securities, which replaced the former in 2009. No matter—in practice the two figures are typically almost identical.)

TIPS and Conventional Bonds

Let’s take another look at the relative value of TIPS, this time compared not with their own history, but instead with those of conventional 30-year Treasuries. Of course, we cannot directly contrast the real yields of TIPS with the latter’s nominal yields. Doing so would be apples-to-grapefruits. We can, however, place the securities on roughly equal footing by subtracting the expected inflation rate from the yield of conventional Treasuries. That figure, called “the breakeven rate” (derived and explained in Tuesday’s column), is currently 2.29%.

Here are the real yields on 30-year TIPS and long nominal Treasuries since August 2004.

Real 30-Year YIelds: TIPS and Conventional Bonds

(Assuming 2.29% Inflation Rate, August 2004-Sept. 13, 2023)

With the brief exception of 2008, when TIPS went on sale while conventional bonds rallied, the lines have moved in tandem. From this evidence, two conclusions may be drawn. The first is obvious: The valuations of TIPS and traditional bonds are closely related. Where one goes, so likely will the other.

The second conclusion is less intuitive. The marketplace’s long-range inflation forecast has barely budged over the past 19 years. This chart was created using only today’s inflation estimate, with no attempt made to discover what investors once believed. Yet despite the simplicity of the approach, the lines correspond. (Their statistical correlation is 0.93.)

What has changed over the years has been investors’ willingness to pay for government-guaranteed income. In particular, that willingness has greatly declined since the early-2020 arrival of the novel coronavirus, making both varieties of Treasuries relative bargains.

Inflation Forecasts

So far, my argument has applied as much to conventional Treasuries as to the inflation-protected version. But now arrives the crucial difference. This analysis has been based on an annual inflation outlook of 2.29%. During the 2010s, when annual inflation only once breached 3%, that mindset was sensible. These days, it smacks of overconfidence. (Even as an inflation optimist, I have my limits.)

Given recent events, as well as the ever-rising level of national debt, it seems prudent to treat future inflation prospects from a neutral perspective rather than being distinctly optimistic. From that mindset, the most relevant inflation estimates are 1) the lowest 30-year average that the United States has experienced, 2) the median amount, and 3) the highest total. Those numbers should permit us to set reasonable expectations.

The following illustration shows the advantage (or not) that 30-year TIPS would have over their conventional counterparts, for buy-and-hold investors, assuming those three conditions. The chart’s inflation projections are derived by calculating the annualized averages for all monthly 30-year rolling periods from January 1926 through August 2023. The lowest inflation level was 1.35%, the median was 3.50%, and the highest was 5.41%.

Prospective 30-Year Returns: TIPS Minus Conventional Treasuries

(IRR%, Assuming Lowest, Median, and Highest HIstoric Inflation Rates)

To be sure, your mileage may vary. If you firmly believe that modern central bankers will not permit a repeat of 1970s inflation, then you will likely be equally enamored with nominal bonds. I am not quite sure how anybody could outright prefer conventional Treasuries, though. Doing so would require substantial faith that long-term annual inflation will not greatly surpass 2.29%. That strikes me as the triumph of hope over experience.

Shorter-Term Prospects

This discussion has applied solely to TIPS held to maturity. (It is not, however, restricted to 30-year securities, as the analysis is broadly similar along all points of the TIPS yield curve.) The question then becomes, what of investors who do not stay the course? As 2022 demonstrated, although TIPS are by definition profitable when bought and held, they can incur large losses if sold along the way.

The answer lies with real interest rates. The level of future inflation is immaterial. What matters instead is whether TIPS yields continue to rise. Were that to occur, those increases would cause capital losses. Stranger things have happened, but I certainly would not count on that possibility. Today’s 2% yield on TIPS matches the long-term real return for intermediate-term government notes, which unlike TIPS offer no inflation protection. That makes for an unusually attractive deal.

The views expressed here are the author’s.