It's Probably Time to Dial Back TIPS Expectations

With the Consumer Price Index (CPI) on a seemingly never-ending run to the upside this year, advisors are engaging in plenty of inflation-related conversation with clients.

Of course, those chats involve assets and ideas that should be avoided and embraced during inflationary times. Predictably, Treasury inflation-protected securities (TIPS) are part of those conversations. While a prosaic solution to inflation fighting within client portfolios, TIPS are doing their job this year.

For example, the iShares TIPS Bond ETF (TIP), the largest dedicated TIPS exchange traded fund, is higher by 6% year-to-date. That's an excellent showing, particularly relative to aggregate bond funds as the widely followed Bloomberg US Aggregate Bond Index is off nearly 2% this year.

Underscoring the strength of TIPS in 2021, that was far and away the best-performing segment of the fixed income market in October and one of just four that delivered positive returns. The other three were investment-grade corporates, short-term junk bonds and senior loans. Last month, TIPS topped Treasuries, mortgage-backed securities (MBS) and high-yield bonds, among others.

In other words, TIPS are on quite the run and with inflation proving more persistent than transitory, it's possible these bonds offer more near-term, maybe even medium-term, upside. However, some market observers argue that TIPS could disappoint next year.

Rising Rates Could Foil TIPS

Admittedly, TIPS won't necessarily falter or tumble if the Federal Reserve raises rates next year, but the performance of inflation-link bonds when rates rise is something for advisors to consider.

“As of October 29, TIPS had a duration of 7.7 years. That means that if U.S. Treasury Rates rise 1%, TIPS could fall 7.7%. TIPS protect investors from rising inflation expectations—not rising interest rates,” says Daniel Bush, ProShares senior investment strategy analyst. “While our research indicates that TIPS have historically outperformed the nominal Treasury market during periods of rising rates, hedging interest rate risk rather than inflation has been the more direct and effective solution.”

Bush's point that TIPS are inflation, not interest rate protectors is relevant because clients – without the guidance of an advisor – can be deceived by the fact that inflation expectations often rise alongside expectations of higher interest rates. However, the latter can move higher without inflation being in place. Still, advisors can deliver better solutions to clients than TIPS in rising rate environments, which is something to prepare because at least one rate hike is coming in 2022.

“The FTSE Corporate Investment Grade Index, which tracks interest-rate hedged corporate bonds, has done even better,” adds Bush. “That’s because interest rates can rise even if inflation expectations don’t. In fact, that’s what tapering is intended to achieve: A rise in real interest rates or a rise in interest rates that is either not accompanied by rising inflation expectations or that is in excess of rising inflation expectations. And that’s a recipe for disappointing TIPS performance.”

TIPS: Too Good to Be True?

Obviously, two things cannot be refuted. Inflation is rising – it's likely to seep into at least the first quarter of 2022 – and TIPS are performing as expected.

However, TIPS might not be able to keep up this torrid pace. Consider this. For the six years ending 2020, the aforementioned TIP ETF beat the Bloomberg US Aggregate Bond Index in just two of those years. Add to that, there factors looming right now that don't necessarily bode well for TIPS in 2022.

“Today’s period of extremely low real interest rates and elevated inflation expectations may be precisely the wrong time for TIPS,” concludes Bush. “The Fed wants real interest rates to rise and inflation to be kept in check. Interest rate hedged bond strategies, which invest in portfolios of investment grade or high yield bonds and include built-in hedges directly targeted at mitigating the impact of rising Treasury rates, may be a better choice.”

Related: New ETF Offers Clients a Lot to Like