Demystifying TIPS

TIPS have a history of cycling in and out of investors’ minds as a du jour investment idea. At their core, TIPS can typically provide a hedge against inflation for a broader fixed income portfolio, but they also have many distinct, often misunderstood, features. Below, we examine TIPS and seek to debunk several misconceptions.

What Are TIPS?

First issued by the US government in 1997, TIPS were designed to provide investors with inflation protection. The TIPS market has grown to about $2.1 trillion, representing roughly 7% of total Treasury issuance.ⁱ Like any asset class, supply and demand can impact valuations. The US Treasury has gradually increased TIPS issuance in support of targeting 8 to 9% of Treasurys outstanding, signaling a continued commitment to the TIPS program.ⁱⁱ

In practice, the principal value of TIPS increases with inflation and decreases with deflation. Multiplying the adjusted principal by the fixed coupon rate calculates the semiannual coupon payments, so coupons also float relative to the inflation environment. When TIPS mature, the Treasury repays the adjusted or original principal, whichever is greater, creating a deflation floor. Older-issue TIPS are more sensitive to deflation since it erodes accrued inflation. Additionally, coupon payments do not enjoy similar deflation protection because coupon payments may be calculated on an adjusted principal less than par. As a result, there is some deflation risk.

TIPS principal adjustments are calculated monthly with a three-month lag based on changes in the Consumer Price Index for Urban Consumers non-seasonally adjusted (CPI-U). The CPI-U measures changes in the price paid by urban consumers for a basket of consumer goods and services. Shelter, food, transport, energy and medical care prices make up almost 75% of the index.ⁱⁱⁱ 

COMPONENT OF US CPI-U CONTRIBUTION

Source: Haver Analytics, as of 30 September 2024.
Used with permission from Haver.

What Are Breakeven Inflation Rates? 

A breakeven inflation rate is the annualized rate of CPI-U inflation that makes the total return of a TIPS equal the total return of a similar-tenor Treasury. Breakeven rates are calculated as the yield difference between Treasury bonds and TIPS of the same duration.^iv

Breakeven rate calculations act as a proxy for the market’s inflation expectations. The smaller the rate, the lower expectations are for inflation. Higher rates indicate increasing inflation expectations. A change in market expectations or uncertainty about inflation can change TIPS prices even if realized inflation remains constant.

If Inflation Expectations Increase, What Can I Expect?

Ten-year breakeven inflation (expected inflation for the next ten years) is currently hovering just below 2.19% and the five-year average for 10-year breakevens sits around 2.16%.^v

10 YEAR BREAKEVEN INFLATION

Source: Bloomberg, as of 30 September 2024.
Used with permission from Bloomberg Finance L.P.

If Energy Prices Rise, What Can I Expect?

If energy prices increase, CPI-U will likely rise, and in turn, TIPS could benefit from principal accretion and higher coupon payments. If the energy component in CPI-U were to increase 5% year over year, we would expect a 0.3% to 0.6% contribution to CPI-U based on the historical weighting of the energy component.

ENERGY PRICES CONTRIBUTING TO CPI-U

Source: Haver Analytics, as of 30 September 2024.
Used with permission from Haver.

When Do TIPS Outperform Treasurys?

Nominal Treasurys can lose real value when realized inflation exceeds inflation expectations at the time of a bond’s purchase. In such an environment, TIPS typically outperform nominal Treasurys. When realized inflation is lower than breakeven inflation, nominal Treasurys usually outperform TIPS.

However, we believe there are some important nuances to the nominal Treasury/TIPS dynamic, mostly depending on whether changes in real or nominal rates are driving inflation expectations. Total returns for TIPS and nominal Treasurys are linked to real economic growth in the long run. In an environment of rising inflation and low growth, we would expect real yields to fall and TIPS to have a positive return, while nominal Treasury bonds may have a flat or even negative return. In an environment of rising inflation and higher growth, TIPS may still outperform nominal Treasurys but could lose value as real interest rates rise along with breakeven inflation.

The grid presented above is shown for illustrative purposes only. Some or all of this information on these charts may be dated, and, therefore, should not be the basis to purchase or sell any securities. The information is not intended to represent any actual portfolio.

Why Consider the Loomis Sayles Inflation Protected Securities Fund?

TIPS are more complex and nuanced than investors may initially think. To help capitalize on these dynamics, the Loomis Sayles Inflation Protected Securities strategy has broad flexibility. We actively manage a core TIPS portfolio and seek to enhance performance by leveraging our deep expertise across derivatives and other credit sectors. As a result, we believe the strategy can capitalize on higher inflation and breakeven rates with strategies not typically available to long-only TIPS managers.

EXPRESS OUR VIEWS ON INFLATION EXPECTATIONS WITHOUT ASSUMING DURATION RISK

TIPS can lose value if real interest rates rise despite higher inflation expectations. However, the strategy can purchase TIPS and short nominal Treasury exposure, expressing a view on the direction of breakeven rates.^vi Historically, this trade pairing generally had positive returns when breakeven rates moved higher, whether real rates were moving higher or lower.

ACTIVE DURATION MANAGEMENT

The duration of the Bloomberg US Treasury Inflation Protected Securities Index is about seven years.^vii The strategy is designed to have a duration four years shorter or longer than the index. If real rates begin to rise with higher growth expectations, the strategy can hedge interest rate risk and seek to protect capital by shortening duration using derivatives.

ACCESS TO ADDITIONAL ALPHA SOURCES

The strategy allows for up to 20% non-TIPS exposure, including nominal Treasurys, asset-backed and mortgage-related securities, and investment grade and high yield corporate bonds. We may also use rate derivatives. We believe this additional flexibility offers the potential to enhance returns at the margin based on our broader economic and credit views.