Dec 11, 2016 | Post by: Roman Chuyan, CFA Comments Off on TIPS Are Not On The Menu – Just Yet

TIPS Are Not On The Menu – Just Yet

  • Inflation may continue to rise in the coming months.
  • TIPS protect against inflation, but come with their unique risks, including rising interest rates.
  • The time to invest in TIPS is not yet, but we are close.

In this post, I’ll describe Treasury Inflation-Protected Securities, or TIPS. These inflation-indexed bonds offer protection against rising prices by paying interest adjusted for inflation. Interest is calculated to reflect the Consumer Price Index for All Urban Consumers, CPI-U or simply CPI – the headline, most widely used measure of U.S. inflation.

Maintaining real income is an important part of retirement planning and pension management. Inflation is arguably the deadliest enemy of long-term investors. This is especially challenging for older and risk-averse investors, as their portfolios tend to be tilted toward fixed income, which may fall short if inflation rises. Real estate, dividend income, etc. help, but also come with risk.

Rising Inflation

Inflation was very low in the past couple of years, but rose this year, as I described earlier. Core inflation, which excludes food and energy, has remained between 2% and 2.3% for about a year, and currently stands at 2.1%. Total CPI inflation has begun to rebound – in fact, it jumped from 1.1% in August to 1.6% in October. This, of course, is still fairly low, but so are interest rates, despite their recent jump. Intermediate-term bond yields, around 2%, still barely compensate for current inflation.

Inflation and Oil Price, 5 YearsInflation - tactical investment management

And inflation will likely rise in the coming months. It’s only a matter of time, in my view, before total CPI rises to core inflation (2.1%). The rationale remains unchanged since my previous articles: energy prices are the most important driver. In addition, President-elect Trump’s proposed pro-growth policies are viewed as inflationary.

So TIPS, with their automatic inflation protection, seem like a great solution, right? Yes and no – the benefit comes with unique risks.

Price Performance of TIPS

Let us take a look at their previous large declines. Despite their floating-rate nature, TIPS prices react to nominal Treasury yields in a similar way to nominal bonds. Their prices are inverse to yields. TIPS monthly correlation to the Barclays U.S. Aggregate index is fairly high at 0.76.

TIPS Total Return vs. 10-Year Treasury Yield, 2004-2016

TIPS vs 10y Treasury yield - tactical management

As you can see on the chart above, TIPS dropped by about 10% during the 2013 “taper tantrum,” and their total return is yet to recover to previous peak. As interest rates rose this quarter, TIPS prices began to drop again.

TIPS vs. CPI Inflation, 2004-2016

TIPS vs Inflation - tactical investment

You can see here that there is some correlation with inflation. This turned out to be deadly for TIPS in 2008 as inflation plummeted – the price dropped by 16% from peak to trough in 2008, even though nominal Treasuries gained in that period.

TIPS vs. Real 10Y Yield, 2004-2016

tactical investment management

Lastly, we can view these securities as providing income equal to CPI inflation, plus real yield over inflation. However, this real yield varied widely, from 2.5% to -0.7% in the past 12 years. In retrospect, it was a bad idea to invest at negative real yield. Even though you missed part of the rally in 2012, it was more then justified by avoiding the 2013 carnage.

When To Invest

To tactical investors (meaning, those not satisfied with buy-and-hold approach), entry and exit points are very important. If you agree that interest rates will rise a bit higher in the short term, as I described most recently here, then the price may fall some more. But rising inflation provides support, so TIPS price drop may not be as steep as it was in 2013 for the same change in nominal yield. Our models that incorporate the factors above tell us that we are getting close – please stay tuned for updates.

If you are a regular reader of MCM’s Tactical Strategies reports, you had an advantage of our timely recommendation earlier this year to stay away from longer-term bonds, including TIPS, along with recommendations for high-quality income ETFs with no exposure to interest rates. Learn more about our fundamentals-based, forward-looking approach to tactical investment management. If you are an advisor and are interested in adding a tactical component to your practice, please contact us to begin receiving the report.

Disclosure: I/we have no positions in the securities mentioned. We use the securities as an illustration of market performance, and not as a buy or sell recommendation.

Additional disclosure: Roman Chuyan is the president and general partner of Model Capital Management LLC, a Registered Investment Adviser. This article is for informational purposes only. There are risks involved in investing, including loss of principal. Roman Chuyan makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Model Capital Management LLC. There is no guarantee that the goals of the strategies discussed in this article will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any security.

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