Head of the Class | Published in July 2005

TIPS Ahoy!

Time for another look at Treasury Inflation-Protected Securities?

By John Keefe | July 2005

Time for another look at Treasury Inflation-Protected Securities?

» Motivating Factors

"The shares of American companies which manufacture ice tend to sell at a higher price in the summer, when their profits are seasonably high, than in the winter, when no one wants ice," wrote John Maynard Keynes in his 1936 economic manifesto, The General Theory. His example explains institutional investors' attitudes toward Treasury Inflation-Protected Securities, or TIPS, when they were first issued in 1997: The existing markets were doing very well, and no one needed inflation protection, so most institutions ignored the opportunity to lock in a low, certain rate of return.  

A market crash and a few oil scares later, the US inflation rate now seems to have nowhere to go but up. TIPS are still a small market—outstandings are just $260 billion, with a current market value of $318 billion—and there is a small universe of managers running them, with a few wringing considerable value from this new market.   

For the first two years of their existence, TIPS performed poorly, relative to conventional "nominal" bonds, due less to inflation conditions than to investors' scant awareness of the new instruments (see "TIPS Sheet," below).

After the Great Unpleasantness of 2000, however, sponsors' attention began to turn toward investments offering less uncertainty and volatility, like TIPS. Seamus Brown, vice president at JPMorgan Asset Management in London, tells investors to ignore the historical return data.   "Lately, TIPS have come back into vogue, and the excess returns of the last three years may never be replicated."

Of course, the purpose of TIPS is not to beat one market or another; rather, it is to find returns that match a plan's inflation--sensitive liabilities. "In TIPS, you have an asset class that performs well when inflation rises, as opposed to nominal bonds, which tend to perform poorly," observes William Lloyd, director of portfolio strategy at Bridgewater Associates in Westport, Connecticut, a large and innovative manager at the top of the shortlist of TIPS track records. "With inflation-linked bonds, if inflation is rising, the price of the security won't drop, and you'll get a higher coupon as well."

The interest rates on nominal government bonds are made up of three theo-retical components, explains Glenn Baker, head of fixed income at Brown Brothers Harriman in New York, and a partner of the firm. "There's a real interest rate; a premium for the inflation that's expected over the life of the bond; plus compensation for uncertainty about what inflation will actually turn out to be." Because each of these parts represents a set of market expectations, they cannot be measured precisely.  

"Compare that to an inflation-linked bond," Baker continues. "You can see the real interest rate directly—it's the coupon rate on the bond [fixed at the time of issuance]." He adds, "There's no inflation expectation component in the interest rate. Instead, the principal of the bond is adjusted up and down, as inflation rises and falls." For example, if a TIPS real-rate coupon is 2%, and the rate of inflation in its first year is 4%, the investor is paid 2% on an adjusted principal of 104.  

TIPS quickly adjust themselves to changing conditions—inflation rates are factored in based on monthly consumer price index (CPI) reports—but the financial markets usually forecast inflation for pricing nominal bonds pretty effectively and, over a long investment period, the forecast errors probably would cancel out. So, is there a real benefit to TIPS for long-term investors? "For the long haul, 20 or 30 years," says Baker, "you would get approximately the same return as on a nominal Treasury of the same maturity, but TIPS should produce less volatility in prices."  

"We don't recommend inflation-linked bonds for the lower volatility," says Brown, "because we think that, in the future, they will have equal or higher volatility than nominal securities in some circumstances. Instead, we like them for the low correlation of returns with nominal securities and other asset classes." The correlation between the Lehman Aggregate and US TIPS indices was about 0.70 for the first seven years of the bonds' lives. That is not a low correlation, concedes Lloyd, but, "during the short life of TIPS, inflation has been stable, and you would expect to see a high correlation when only real yields have been driving both markets." If inflation were to rise, however, and bounce around inside a wide range (say 4% to 6%), so that inflation expectations rather than real yields were the main influence, Lloyd asserts that correlations between TIPS and other fixed-income assets will fall, and provide the greater diversification needed. "In view of the similar expected return between TIPS and comparable nominal Treasurys, and the lower risk," Lloyd adds, "we think inflation-linked bonds are a must-have asset."  


Motivating Factors

The essential motivation for plans to own TIPS today, however, is to facilitate asset-liability management—keeping asset values on track with growth in liabilities. "Many pension plans, especially on the public side, pay benefits that are linked to inflation," notes John Brynjolfsson, managing director and real-return portfolio manager at PIMCO. "Even plans that pay fixed benefits have an exposure to inflation—through their active participants, whose benefits are determined by their last few years of salary."

"TIPS can hedge the CPI component of wage inflation, but not the rest of it," cautions Barton Waring, managing director at Barclays Global Investors and head of the firm's client advisory group. The 30% or so difference between wage inflation and the CPI is a complex function of productivity, GDP growth, and other factors, that don't lend themselves to hedging, Waring says. "However, that 70% is a pretty good step in the right direction."

More impartial observers of the TIPS market—investment consultants, rather than managers—are less rhapsodic. "TIPS can be useful in the arsenal of an actively managed portfolio, such as a core plus mandate, where a manager has a point of view on inflation, and can capitalize on it through the TIPS market," contends Brian Birnbaum, principal at Ennis Knupp + Associates in Chicago. "However, if you believe that the market as a whole makes a good forecast of long-term inflation," he adds, "then there probably is no benefit to a strategic allocation to TIPS"—because more suitable inflation hedges are available, and likely already in a plan's portfolio.

For the traditional institutional investor—with a 15- to 30-year time horizon, and a significant allocation to equities—Birnbaum says it is not clear that explicit protection against inflation through TIPS is necessary, as equities themselves are an effective inflation tracker. Since 1970, he reports, US equities have averaged an annual return of 6.2% above inflation. For short periods, however, equities would not be a reliable hedge, while returns on TIPS would match the CPI irrespective of what happens in the surrounding markets.  

The bottom line on TIPS for Bill Dewalt, director of research for Watson Wyatt in Atlanta, is not the hedge, but the yield on TIPS. He notes: "In the end, they earn just a Treasury return, and that makes them less attractive for a strategic allocation." That low return, however, includes an implicit deduction for the cost of the inflation hedge, and will be attractive to sponsors that desire that sort of insurance.

"Most pension plans using TIPS have just dabbled in them, with policy positions of 2.5% or 5% of their portfolios," notes Brynjolfsson. "Due to their low risk and inflation hedging capability, optimizers suggest that plans might hold 25% or 50% of their assets in inflation-linked bonds."  

Brynjolfsson posits that inflation-linked bonds are the ultimate riskless asset: "Cash can provide a positive or negative real return, which can become substantially positive or negative over 20 years, while TIPS pay a fixed real return when held to maturity. That's even more riskless than cash."