US TREASURY TIPS: “THEY ARE NOT ALWAYS WHAT WE THINK THEY ARE”
By Michael Rulle
We first became interested in TIPS when working with S&P on developing their S&P Risk Parity set of indices. We spent a great deal of time debating the pros and cons of including TIPs in a Risk Parity benchmark index. On the surface, one would think a strategy such as Risk Rarity, which explicitly attempts to hedge against unexpected inflation as one of its investment features, would include TIPS as an obvious choice for one of its constituents. In the end we decided it did not belong in an investable Risk Parity benchmark. The following, in part, explains why we made that decision. In the end, we chose commodities for the inflation hedge. For this short blog, we will only discuss our thoughts on TIPs.
TIPS BUY and HOLD
When I first read about Treasury Inflation-Protected Securities (“TIPS”) I thought they were ingenious and easy to understand. Also, I really appreciated that we would finally have a market-based expectation of inflation by comparing TIPS yields with Nominal Yields on traditional Treasuries.
My initial perception was correct, for what I was perceiving. What I did not realize was that what I perceived was far less than there was to see. Let us begin with the simplest example—-“Buy and Hold” to maturity. We will compare a nominal fixed-rate 10-year Treasury with a 10-year TIPS. We will also assume one buys each when issued, and then holds each until maturity.
First, the Nominal Treasury works as follows. Assume we buy a 10-year Treasury with a 2% coupon (as I write this the yield-to-maturity on the 10 year Treasury is about 70 basis points—but I cannot get my self to use that as an example — when yields drop to minus 1% perhaps then I will be able to 😊). The investor pays par, or $100, and receives 1% twice a year (in yield to maturity calculations we assume the investor reinvests coupons in the bond). The investor ends up with a 2% annualized return after 10 years. If inflation was 1%, the real return was also 1% per year.
Now we will compare this with TIPS issued at the same time. Assume the expected annual inflation was 1% at the time of issuance. The TIPS, under this condition, would likely be priced with a 1% coupon rather than a 2% coupon. If actual inflation increased at 1% per year the TIPS security, by design, would have its par value increase by 50 basis points every 6 months, or 1% per year. The coupon would remain at 1% but would be applied to the increases in the par value of the bond. Assuming inflation did end up at 1% for that time frame the investor would have the same amount of dollars after 10 years as the investor in nominal treasuries and each would have made 1% annually in “real” terms, i.e., net of inflation.
However, if inflation were zero the TIPS investor would have earned only 1% yield to maturity (and 1% real) while the nominal investor would have earned the same 2% (and 2% real). Conversely if inflation were 2%, the TIPS investor would have earned 3% yield to maturity and 1% real returns. The Nominal bond investor would have earned 2% nominal and 0% real.
Now, as complex as this might seem to someone who has never heard of TIPS before, it is far less complex than what really happens—-because rare is the time investors buy and hold in this manner.
TIPS IN REAL LIFE
Most large investors invest in funds who are buying and selling securities for a variety of reasons, including rebalancing, withdrawals, additions, and market views. If one invests in TIPS funds that are trying to match an index, the results over short periods of time can be quite different. In the practical world of investing, the returns one earns on TIPS versus Nominal Treasuries are not quite so neat as described in a buy and hold scenario.
An excellent article on this topic is “Twenty Years In, Have TIPs Delivered?”, by Morningstar (April 11. 2017). Even though it covers only 17 of the 20 years TIPs have existed, the specific outcomes are less important than the variety of outcomes. The most important factor is how and why prices change over time.
TIPS outperformed inflation by a substantial amount, but so did nominal fixed-rate Treasuries and virtually all other fixed income instruments. But most surprising of all, is that TIPS had almost a zero correlation to inflation when viewed on a monthly basis. TIPS were more volatile than Nominal Treasuries and had a 66% correlation to them as well. Further, they were positively correlated to Equities while fixed-rate Treasuries were negatively correlated. One of the more unexpected features is that even when using a “look back” (i.e. ex-post) optimizer they had a zero allocation within the efficient frontier portfolio—in other words, even when all was known and the optimal decision can be made (which of course is not possible) they could not add value to any portfolio with equities and fixed income.
Strangest of all, is that TIPs have acted like “risk assets”, so in times of crisis they have underperformed by more than one would perceive as rational, not unlike “off the run” fixed-rate Treasuries. It is important to keep in mind, however, that if we had another period like the 1970s it is virtually certain that over that entire time period, they likely would have outperformed most other asset classes (except commodities).
But that is almost precisely the point. For all practical purposes, TIPS are just another asset class. When inflation rises, their “par value” definitely rises, but their market value does not necessarily rise. When real rates rise their prices will fall, when real rates decline their prices will rise, regardless of what nominal rates do—which feels very counterintuitive for a security that is an inflation hedge.
For a long- term investor who will predominantly buy and hold, TIPS will achieve what they promise to achieve if bought at issuance. But as of today (5/28/2020) a buyer of the on the run 10-year TIP who holds it until maturity will earn a negative real rate of return, as its current yield is negative. Even if inflation rises 10%, it will still earn a negative real rate. It will outperform a nominal Treasury bought today by a substantial amount—and future purchases, particularly if bought at par, will, under those circumstances likely earn a positive real rate. But, today, a 10-year TIP held to maturity, will underperform inflation—not what one would intuitively expect for an inflation hedge.
This is what we mean when we say, “TIPS are not always what we think they are”. This does not make them “bad” or “good”. They are what they are — and it is important to understand how their prices change as a function of changes in nominal rates, inflation, deflation, and market liquidity. Like any security or asset class, understanding its nature is critical before investing.
ARE TIPS AN APPROPRIATE INVESTMENT?
This really is two questions in one. First, should TIPS be part of an investable Risk Parity Benchmark, and second, are TIPS an appropriate part of a general diversified portfolio?
We believe Commodities (S&P GSCI) are the best inflation hedge over the long run, and thus for a Benchmark are most appropriate as the inflation hedge asset for a Risk Parity Portfolio. They are a unique asset class, and while their excess returns above the risk- free rate has been 5.45% annualized from 1970-May 2020, since 1980 the excess return has been only 2.00%. However, they have great streaks, both positive and negative. TIPS, on the other hand, like Nominal Treasuries, have done well since they came out in 1997. The problem for a Risk Parity benchmark, is their high correlation with fixed-rate Treasuries, and their positive correlation with Equities, which themselves have a slight inflation hedge as part of their return stream.
But just because we believe TIPS are not the best security for a Risk Parity Benchmark, does not mean they cannot add value to a conventional portfolio of Treasuries. However, their performance has not been so convincing that they are an automatic addition to a Treasury portfolio. They are complex securities to incorporate efficiently within a portfolio. One should note that TIPS have a beta all their own with little correlation to anything else. That can be a good thing, but it is also the reason they do not belong in a Risk Parity benchmark. Certainly, if one is invested in a portfolio which actively trades fixed income, TIPS can provide trading opportunities. However, this accentuates their role in the pursuit of alpha rather than beta which, by definition, is what a benchmark provides.