October 19, 2021
There’s a debate raging over whether inflation is transitory or persistent. The U.S. Federal Reserve recently predicted a higher inflation rate than its previous forecasts due to temporary pandemic-related supply chain bottlenecks, while maintaining its transitory stance. Needless to say, inflation is top of mind for investors—it was recently one of the most Googled financial terms—and many are looking for ways to mitigate the effects of inflation in their portfolio.
One effective solution could be Treasury Inflation-Protected Securities (TIPS). Issued and fully backed by the U.S government, TIPS are designed to keep pace with inflation and preserve the purchasing power of an investment.
So, why should investors consider TIPS ETFs in their portfolio? Let’s take a look at three key reasons.
High inflation expectations have led TIPS to outperform other fixed-income sectors over the last few months and year-to-date, including U.S. Treasuries by over 570 basis points (bps) (year-to-date). In general, TIPS tend to outperform nominal Treasuries if inflation expectations are higher and vice versa. As the below chart highlights, TIPS was the best performing fixed-income sector and one of the few that delivered positive returns since the start of the year. If inflation does in fact climb higher, then TIPS should continue to outperform, while also offering protection against inflation.
Source: Bloomberg and SSGA, as of August 31, 2021. US Agg = Bloomberg Barclays US Aggregate Index | US Treasury = Bloomberg Barclays US Treasury Index | US TIPS = Bloomberg Barclays Global Inflation-Linked: U.S. TIPS Index | US MBS = Bloomberg Barclays US MBS Index | US IG Corp. = Bloomberg Barclays US Corporate Index | US High Yield = Bloomberg Barclays VLI: High Index | Developed Ex-US IG Corp. = Bloomberg Barclays Global Agg Corporate ex USD Index | Developed Ex-US Sovereign Bonds = Bloomberg Barclays Global Treasury ex-U.S. Index | EM Hard Currency Debt = J.P. Morgan EMBI Global Core Index.
In this low-rate environment, TIPS offer negative “real” yield—the actual return when adjusted for inflation. This is because TIPS are indexed to inflation. Given the existing low nominal yields—returns based on the face value of a bond—the actual yield an investor receives is negative after accounting for higher inflation.
The difference between the nominal Treasury yield and the TIPS yield is called the breakeven inflation rate and is a market-based measure of expected inflation. As shown below, this breakeven rate is currently above its long-term average and approaching its highest levels since 2013.
The breakeven rate is also the inflation rate that would make an investor indifferent between owning a TIPS and a Treasury bond of the same maturity. However, if inflation is higher, then TIPS would outperform Treasuries. The bottom-right chart shows why this is the case. In this example, the actual inflation rate (2.85%) turns out to be higher than the breakeven inflation rate (2.35%). As a result, the real yield on the Treasury bond (-1.51%) is lower than the TIPS yield (-1.01%). Thus, an investor would prefer TIPS over a Treasury bond if they believe inflation will be higher.
*Hypothetical inflation rate for illustrative purposes
Source: FRED (St. Louis Fed), as of September 16, 2021. Nominal yield based on 10-Year Treasury yield. Real yield based on 10-Year Treasury yield less inflation rate. Breakeven inflation rate based on 10-Year Treasury yield less 10-Year TIPS yield.
While there are other asset classes that provide some buffer against inflation, they are not without risk. The below chart shows the worst 12-month total returns for various asset classes and illustrates that higher returns also come with higher volatility.
For instance, asset classes such as commodities and real estate, which have traditionally been considered for their inflation-hedging properties and their ability to outperform in inflationary environments, have also experienced some of the largest drawdowns. TIPS on the other hand, which provide inflation protection albeit with lower returns, have significantly less risk relative to other asset classes. Ultimately, investors should consider the volatility of an asset class in addition to its ability to hedge against inflation.
Source: Morningstar Direct, as of August 31, 2021. Commodities = S&P GSCI | Real Estate = FTSE EPRA Nareit Developed | EM equities = MSCI Emerging Markets | International equities = MSCI EAFE | US equities = S&P 500 | Gold = LBMA Gold Price PM | US HY = ICE BofA US High Yield | US IG Corp = ICE BofA US Corporate | US MBS = Bloomberg US MBS | US TIPS = Bloomberg US Treasury Inflation Protected Securities | US Treasuries = Bloomberg US Treasury | US T-Bills = Bloomberg US Treasury Bills. Start date for each asset class is as follows: Commodities: December 1970; Real Estate: December 1990; EM equities: December 1988; International equities: December 1970; U.S. equities: January 1971; Gold: April 1969; US HY: August 1987; US IG Corp: November 1976; US MBS: December 1976; US TIPS: February 1998; US Treasuries: December 1973; US T-Bills: November 1992.
TIPS can be an effective and straightforward tool to buffer the effects of inflation. Investors looking to get exposure to TIPs can consider CI U.S. Treasury Inflation-linked Bond Index ETF (TSX:CTIP) to help protect their portfolio against a rise in inflation.
Commissions, management fees and expenses all may be associated with an investment in exchange-traded funds (ETFs). You will usually pay brokerage fees to your dealer if you purchase or sell units of an ETF on recognized Canadian exchanges. If the units are purchased or sold on these Canadian exchanges, investors may pay more than the current net asset value when buying units of the ETF and may receive less than the current net asset value when selling them. Please read the prospectus before investing. Important information about an exchange-traded fund is contained in its prospectus. The indicated rates of return are the historical annual compounded total returns net of fees and expenses payable by the fund (except for figures of one year or less, which are simple total returns) including changes in security value and reinvestment of all dividends/distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. ETFs are not guaranteed; their values change frequently, and past performance may not be repeated.
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