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- TIPS: Tempering Inflation's Potential Surprises
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- 2020-2021: Inflation Surprises Shift the Balance
- FIGURE 1: TIPS TO OUTPERFORM AMID 2020-2021 INFLATIONARY SURGE
- When Inflation Surprises, TIPS Shine
- FIGURE 2: TIPS OUTPERFORMANCE TRACKS INFLATION SURPRISES IN H2 2020-2021
- TIPS in 2022 and Beyond
- Tipping the Scales of Inflation Hedging
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Treasury Inflation-Protected Securities (TIPS) often get a bad rap. At first glance, the relative simplicity of nominal Treasury bonds might make them the obvious choice for a fixed income investor.
After all, the decision between a nominal Treasury bond yielding i% and a TIPS bond yielding r% — with inflation expected to be (i - r)% over the bond’s life — seems to be straightforward. So what difference does it really make?
For the sake of argument, assume that realised inflation equals expected inflation. Even in this case, the path of coupon payments would look very different. Nominal Treasuries pay a fixed coupon semi-annually. TIPS, however, provide variable payments, with coupons adjusted based on changes in the Consumer Price Index (CPI)2. For investors facing liabilities that rise with inflation, TIPS offer a hedging advantage that nominal bonds can’t replicate.
It gets especially interesting when realised inflation differs from expectations.
2020-2021: Inflation Surprises Shift the Balance
The aftermath of the COVID-19 economic recovery brought a dramatic inflationary surge that few anticipated. At the end of 2020, the Cleveland Fed’s one-year inflation expectation estimate stood at an unassuming 1.65%. However, CPI soared by 7% (seasonally adjusted) over the following year — a massive 5% surprise1.
Yet even as inflation surged, markets clung to the narrative of “transitory” inflation. The Fed’s commitment to low rates translated to both real and nominal bond yields remaining relatively flat throughout 2021. But TIPS had a card up their sleeve. The price adjustment tied to higher realised inflation boosted their performance, leading TIPS to outperform nominal Treasuries with similar maturities.
This dynamic is evident in Figure 1, which illustrates cumulative total returns from mid-2020 through the end of 2021. While the Bloomberg US Treasury 7-10yr Index declined, the Bloomberg US Government-Linked 7-10yr Index, which includes TIPS, rose approximately 10%.
FIGURE 1: TIPS TO OUTPERFORM AMID 2020-2021 INFLATIONARY SURGE
When Inflation Surprises, TIPS Shine
The connection between inflation surprises and TIPS outperformance is also clear in Figure 2, which tracks rolling one-year total returns of TIPS versus nominal Treasuries alongside the US Citi Inflation Surprise Index. Typically, when inflation surprises on the upside, TIPS tend to outperform Treasuries. On the flip side, in periods with little or no inflation surprises, performance between the two tends to be very similar.
FIGURE 2: TIPS OUTPERFORMANCE TRACKS INFLATION SURPRISES IN H2 2020-2021
TIPS in 2022 and Beyond
While TIPS outperformed in the back half of 2020 and into 2021, they weren’t immune to the bond market sell-off of 2022, during which the Treasury index fell roughly -15% and the TIPS index dropped by around -14%. A slim 1% outperformance isn’t nothing, but it’s also not something to write home about.
Why the similar results? By 2022, both markets and the Fed recognised that inflation wasn’t transitory and significant interest rate hikes would be needed to rein in inflation, which drove nominal yields sharply higher. However, breakeven inflation remained relatively contained3 reflecting confidence in the Fed’s ability to restore price stability. Consequently, rising nominal yields translated into rising real yields4. Since TIPS and nominal Treasuries shared comparable duration profiles, both indices had similar performance.
Tipping the Scales of Inflation Hedging
While TIPS exposure isn’t a panacea for inflation hedging, they serve as a powerful complement to a broader strategy, delivering results when conditions align with their unique benefits. When inflation takes an unexpected turn, TIPS can deliver returns that outshine traditional Treasuries, providing a key edge in volatile environments. By understanding their role and limitations, investors can position TIPS as a strategic tool to capture upside opportunities while effectively navigating inflation risks.
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in the portfolio at the time of publication and, if such securities are held, no representation is being made that such securities will continue to be held.
The views expressed herein are those of PGIM investment professionals at the time the comments were made, may not be reflective of their current opinions, and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither PFI, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
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