A Few Tips on TIPS

A version of this article was published in the December 2021 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

As consumer prices have surged at the fastest pace in over 30 years, investors concerned about inflation may be interested in understanding what options are available to protect against a loss in purchasing power. Treasury Inflation-Protected Securities are a pure-play inflation hedge, and funds that invest primarily in TIPS can offer investors diversified exposure to the TIPS market. Like U.S Treasuries, TIPS carry minimal credit risk, but unlike Treasuries, TIPS have a built-in feature that adjusts their principal value to keep pace with inflation (as measured by the Consumer Price Index). This may sound straightforward, but there are some important features of TIPS that investors should consider before investing.

While they might seem to be risk-free, TIPS are certainly not immune to short-term price swings, whether they're driven by investor sentiment or moves in interest rates. Indeed, U.S. TIPS are exceptionally sensitive to changes in interest rates, as TIPS issuance has been clustered in longer maturities. Changes in the CPI will impact a TIPS' price by adjusting its principal value, but an increase in interest rates can have an outsize impact on the price because of the longer-duration profile. This is an important feature to consider, as credit risk is muted for both TIPS and U.S. Treasuries, so the primary performance driver for these government bonds is the interest-rate risk they carry.

Yields on these instruments can also provide insights to the market's expectations around inflation through what is known as the break-even inflation rate. This is calculated by taking the yield difference between a nominal Treasury and a TIPS of the same maturity. When inflation averages higher than the break-even rate, TIPS are likely to outperform their nominal Treasury counterparts and vice versa. For example, the 10-year break-even rate was 2.93% on March 14, 2022, well below the 7.90% increase in the CPI over the past 12 months that was announced earlier in the month. Theoretically, market conditions are ripe for TIPS and TIPS funds to thrive.

Let's look at a couple of competitive offerings in the inflation-protected bond Morningstar Category.

Vanguard Short-Term Inflation-Protected Securities Index VTAPX earns a Morningstar Analyst Rating of Gold thanks to its risk-conscious profile and ultralow fees. This index fund is concentrated on the shorter end of the TIPS market, and it consequently courts less interest-rate risk than its peers. While this somewhat limits the fund's upside potential compared with peers, this bent should also boost the fund's effectiveness as a longer-term inflation hedge, as short-term interest rates are more correlated with the CPI than long-term rates. For example, when the yield on 10-year Treasury bonds increased to 2.45% from 1.51% starting in August 2016 through December 2016 and inflation expectations grew, the average peer lost 1.17%, while this fund gained 0.19%.

Pimco Real Return PRTNX carries an Analyst Rating of Neutral, though it is the only strategy in the category that earns a Process Pillar rating of High. (Its cheaper share classes, which have higher minimum investments, earn Silver and Bronze ratings.) The team employs macro-driven strategies (driven by real growth, inflation, and country-specific analysis) and micro-driven themes (including CPI seasonality, on-the-run/off-the-run premiums, and implied inflation volatility) to position the strategy. Inflation-linked bonds typically dominate the portfolio, though the strategy can invest up to 20% in other sectors, such as corporates and securitized fare. The approach has led to sizable off-index bets at times, distinguishing it from more-constrained peers. This adventurous nature can cause the strategy's performance to diverge from that of the U.S. TIPS market at times, though it has been successful over the long term. The fund outperformed the inflation-protected bond category's average return over the trailing three-, five-, and 10-year periods ended February 2022.