A Tip for TIPS (Treasury Inflation Protected Securities)

Inflation, as measured by year-over-year changes in the Consumer Price Index (CPI), reached a level last year that it had not seen in over 40 years. We have written a lot about this over the last few months, and we will continue to do so because the erosion of purchasing power is one of the greatest risks an investor will face as they save for retirement.

One of the potential ways to protect against the threat of inflation is through Treasury Inflation-Protected Securities (TIPS). TIPS are simply treasury bonds that are indexed to inflation. Here is a more precise explanation, courtesy of Investopedia:

As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) to maintain their real value. The interest rate on a TIPS investment is fixed at the time of issuance, but the interest payments keep up with inflation because they vary with the adjusted principal amount.

TIPS can be invested in directly, or they can be accessed through mutual funds and exchange-traded funds (ETFs) like the iShares TIPS Bond ETF (TIP). It may seem too good to be true. Just buy TIP in my client’s investment portfolio, and now they don’t have to worry about high inflation! Unfortunately, it isn’t that simple. You see, TIPS are still bonds, and they are subject to interest rate risk just like any other bond. As interest rates rise, bond prices fall. In 2022, even as inflation skyrocketed, the rise in interest rates hurt the performance of TIP more than the inflation adjustment helped it.

Here at iSectors we utilize a TIPS ETF within our dedicated inflation model portfolio, the iSectors® Inflation Protection Allocation, but we target a particular slice of the TIPS universe, as opposed to the broad exposure offered by TIP. We use the iShares 0-5 Year TIPS Bond ETF (STIP). STIP only has exposure to the short end of the yield curve, which eliminates much of the interest rate risk present in TIP. In fact, by reducing this interest rate risk, STIP becomes almost a proxy for inflation itself. The price will move much less based on changes in interest rates due to the lower duration of shorter-term bonds, and the inflation adjustment will account for a higher percentage of the price change because of that. The numbers prove this out, with STIP exhibiting a higher correlation to changes in the CPI than TIP.

When STIP is blended with other investments that exhibit strong performance in inflationary periods, such as commodities, precious metals, and other real assets, it can help lower an investor’s total portfolio volatility and protect against the threat of inflation at the same time. This is precisely what we have done within the iSectors® Inflation Protection Allocation. When blended with a traditional stock/bond portfolio, this model can help improve risk-adjusted returns, specifically in high inflationary periods like we are currently experiencing.

For more information about how you can blend this model portfolio with your other investments, or for more details on any of the data referenced above, please contact us.