Treasury Inflation-Protected Securities (TIPS) are an often misunderstood fixed income asset class. Some investors hear “inflation-protected” and assume that TIPS returns are perfectly correlated to changes in inflation. In reality, however, they are not. Learning more about the nuances, mechanics and potential benefits of TIPS can help you integrate this asset class into portfolios.
A relatively novel class of bonds, Treasury Inflation-Protected Securities were introduced in the United States in 1997. The basic notion behind their construction is to index the principal and income on a US Treasury security to inflation.1
The US TIPS market is the world’s largest inflation-indexed securities market with a market value of over $1.87 trillion.2 The Federal Reserve (Fed) is a major buyer of TIPS, currently holding $362 billion in its System Open Market Account Holdings of Domestic Securities (SOMA) account.3
Because the overall market size of TIPS is smaller than that of traditional Treasuries ($10.14 trillion),4 supply and demand factors can have a greater impact on the price of TIPS than regular Treasuries. For example, as a result of the Fed asset purchase program, the net supply of publicly held TIPS declined by $184 billion in 2020,5 contributing to TIPS prices appreciating on the year.
Beyond the market size, TIPS differ from regular Treasuries in three main ways.
TIPS ETFs versus Individual Securities
When deciding how to add exposure to TIPS as an asset class, consider how TIPS exchange traded funds (ETFs) compare to individual TIPS. Figure 1 summarizes these differences.
Figure 1: TIPS versus TIPS ETFs
TIPS ETFs offer three potential benefits:
Fund managers of TIPS ETFs have the option of marketing “SEC yields” on their website, or the annualization of dividends and interest earned per share during the prior 30 days, less expenses, as prescribed by Securities and Exchange Commission (SEC) rules. Given the payment of the inflation principal and the potential elimination of a payment if there is deflation, an ETF’s yield metric may be distorted.
Though the TIPS principal rises with higher inflation, the SEC doesn’t specify whether the SEC yield should include the inflation adjustment to income. Therefore, if inflation is exceptionally high, a fund’s SEC yield that adjusts for inflation will be higher than fund peers that do not include the inflationary adjustment to the principal. However, it may be misleading to include the inflationary adjustment in the SEC yield calculation, as it assumes that on a go-forward basis the inflation reading in the prior months will be persistent and make comparisons difficult.
How the Breakeven Inflation Rate Impacts Performance
Evaluating the breakeven inflation rate — the annualized rate of CPI inflation over the life of the bond that makes the total return of a TIPS equal to that of a similar-tenor Treasury — is also important when comparing TIPS to nominal Treasuries.
Calculated as the yield difference between Treasury bonds and TIPS of the same maturity, breakeven rates are, ultimately, a proxy for the market’s inflation expectations. The lower the rate, the lower the expectation for inflation.
Positive inflation typically benefits the performance of TIPS, while falling inflation (deflation/ disinflation) may cause lower performance. It is important to note that market inflation expectations are often already priced into TIPS. Therefore, for inflation trends to be beneficial for the relative return of TIPS, it must develop at a rate that is higher than the market’s anticipated breakeven inflation rates.
The following example illustrates how the inflation adjustment feature of TIPS works during a period of inflation and what it means for returns. If the US 10-year yield is 1.24% and the yield on a 10-year TIPS bond is -1.16%, this means that the breakeven rate is 2.40%. If inflation over the next 10 years is 2.5%, this would lead to stronger relative performance, all else equal, for TIPS versus nominals, as realized inflation was higher than what was estimated (as represented by the breakeven) at the time of purchase.
A change in market expectations or uncertainty about inflation can change TIPS prices before maturity, however. For example, beginning in April 2021 nominal and real yields both fell. Yet, real yields fell faster as a result of widening breakeven rates and investors’ desire to mitigate the effects of inflation on their Treasury exposure. At the time, therefore, investors felt breakeven rates (i.e., market-based inflation expectations) were understated and not reflective of the loose policy environment. As expectations increased, TIPS outperformed nominal Treasuries by almost 5% through the first eight months of the year.7
TIPS Role in a Portfolio
One of the primary advantages of TIPS is that they are backed by the full faith and credit of the US government. Because TIPS offer the government’s assurance that investors will never receive less than the original face value of the bond at maturity, even in the event of deflation during the life of the bond, TIPS have very low credit risk. And among asset classes used as inflation hedges, TIPS have historically been the least volatile. As shown in Figure 2, compared to equities, commodities or real estate, TIPS have historically exhibited a lower standard deviation of returns.
Figure 2: Asset Class Return and Volatility
While TIPS are directly indexed to changes in inflation, many investors are surprised to see the low correlation between TIPS and inflation. Over the past 10 years, TIPS registered barely any correlation to inflation (1%).8
The low correlation stems from the fact that TIPS, like all bonds, have a duration and changes in interest rates can have a much larger impact on returns. However, on a relative basis to nominal Treasuries, the excess return on TIPS have a 71% correlation9 — underscoring how performance of TIPS should be viewed both on an absolute and relative basis.
As a distinct asset class from Treasuries — and not a component of the widely followed Bloomberg Aggregate Index — TIPS also tend to behave differently from other investments that are commonly found in core bond portfolios. As shown in Figure 3, TIPS are not perfectly correlated to common fixed income investments and have a low correlation to equities, making them a valuable portfolio diversifier. Therefore, including TIPS may help improve the risk/return profile of a diversified portfolio irrespective of the market’s inflation dynamics.
Figure 3: Asset Class Correlation to TIPS (2011–2021)
Rate Risks for TIPS
Like all bonds, TIPS are subject to interest-rate risk. For example, in the first three quarters of 2018 when rates rose without a commensurate uptick in inflation expectations, TIPS registered a negative return (-0.92%).10
One way to reduce the interest-rate sensitivity of TIPS is to use a TIPS portfolio with a shortened duration profile. Figure 4 illustrates how the TIPS 1–10-year index has a 19% shorter duration than the full-duration index but retains most (83%) of the return potential, with 26% lower volatility. In the above example from 2018, 1–10-year TIPS were essentially flat at -0.22%.11
Relative to TIPS overall, those with a shorter duration (1–10 years) can also offer a stronger correlation to inflation (10% vs 1%)12 while offering similar return potential and lower volatility.
Figure 4: Duration, Return, and Volatility of TIPS Exposures
Investors may want to consider adding TIPS to their portfolios. SPDR offers a breadth of inflation-linked ETFs that are designed to protect against inflation in the US as well as in developed and emerging market countries.
SPDR Inflation-Linked ETFs
2Bloomberg Finance, L.P., as of September 30, 2021. Based on the ICE BofA All Maturity US Inflation-Linked Treasury Index.
3Bloomberg, Federal Reserve as of September 30, 2021.
4Bloomberg Finance, L.P., as of September 30, 2021. US Treasury market is based on the Bloomberg U.S. Treasury Index.
5Bloomberg, Federal Reserve, Period: January 01, 2020– December 31, 2020.
6Bloomberg Finance, L.P., as of September 30, 2021.
7Bloomberg Finance, L.P., as of September 30, 2021. Based on the return of the Bloomberg U.S. Treasury TIPS Index and the Bloomberg U.S. Treasury Index.
8Bloomberg Finance, L.P., Period: September 30, 2011–September 30, 2021. Inflation = US CPI Urban Consumers NSA Index; TIPS = Bloomberg U.S. Treasury TIPS Index.
9FactSet, Bloomberg Finance, L.P., based on trailing 12-month returns of the Bloomberg U.S. Treasury TIPS Index and the Bloomberg U.S. Treasury Index from September 30, 2011 to September 30, 2021. Compared to year-over-year changes in CPI.
10Bloomberg Finance, L.P., period: January 1, 2018–September 30, 2018. TIPS = Bloomberg U.S. Treasury TIPS Index.
11Bloomberg Finance, L.P., period: January 1, 2018–September 30, 2018. 1–10 Year TIPS = Bloomberg U.S. Treasury TIPS 1–10 Year Index.
12Bloomberg Finance, L.P., period: July 31, 2011–September 30, 2021. Inflation = US CPI Urban Consumers NSA Index; TIPS = Bloomberg U.S. Treasury TIPS Index; 1–10 Year TIPS = Bloomberg U.S. Treasury TIPS 1–10 Year Index.
Bloomberg U.S. Aggregate Bond Index
A broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
Bloomberg U.S. Corporate Investment Grade Index
Measures the investment grade, fixed-rate, taxable corporate bond market.
Bloomberg U.S. Govt Inflation-Linked All Maturities Index
Measures US dollar-denominated, fixed-rate, inflation linked debt issued by the US Treasury.
Bloomberg U.S. Treasury Index
Measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury.
Bloomberg U.S. Treasury TIPS 1–10 Year Index
Measures the performance of the US TIPs market with less than 10 years to maturity. Federal Reserve holdings of US TIPs are not index eligible and are excluded from the face amount outstanding of each bond in the index.
Bloomberg U.S. Treasury TIPS Index
Measures the performance of the US TIPs market. Federal Reserve holdings of US TIPs are not index eligible and are excluded from the face amount outstanding of each bond in the index.
FTSE NAREIT All Equity Index
A free-float adjusted, market capitalization-weighted index of US equity REITs. Constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.
S&P 500 Index
A widely regarded as the best single gauge of large-cap US equities.
S&P GSCI Index
A widely recognized leading measure of general price movements and inflation in the world economy. Provides investors with a reliable and publicly available benchmark for investment performance for investment performance in the commodity markets.
US CPI Urban Consumers NSA Index
Measure of prices paid by consumers for a market basket of consumer goods and services.
Important Risk Information
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
Investing involves risk including the risk of loss of principal.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs’ net asset value. Brokerage commissions and ETF expenses will reduce returns.
Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation protected debt securities can be unpredictable.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Non-diversified fund may invest in a relatively small number of issuers, a decline in the market value may affect its value more than if it invested in a larger number of issuers. While the Fund is expected to operate as a diversified fund, it may become non-diversified for periods of time solely as a result of changes in the composition of its benchmark index.
The Fund may not purchase securities of any issuer if, as a result, more than 5% of the Fund’s total assets would be invested in that issuer’s securities; except as may be necessary to approximate the composition of its target index. This limitation does not apply to obligations of the U.S. government or its agencies or instrumentalities.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
The views expressed in this material are the views of SPDR Research through the period ended September 30, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
Past performance is not an indication of future performance.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.