2013
How do TIPS protect against inflation, and at what cost?
Orhan Imer, Portfolio Manager
One of the dangers inherent in fixed-income investing is
inflation risk. Fixed-income investors are susceptible to
the risk that rising prices will reduce the purchasing power
of the income their bonds generate. With bond yields
currently at historically low levels, this risk is heightened,
and fixed-income investors face a double-whammy: first,
they are more exposed to the risk of future inflation and
second, they are not being compensated for the current
rate of inflation.
For example, for the most recent 12-month period ending
October 2012, headline inflation was 2.16%, as measured
by the year-over-year change in the CPI-U (Consumer Price
Index for Urban Consumers). This rate was higher than the
yields available on both five-year and 10-year Treasury
securities, which yielded 0.62% and 1.62%, respectively,
as of November 30, 2012.
Treasury Inflation Protected Securities (TIPS) are one
means investors use to protect against inflation risk.
Since the U.S. Treasury first issued TIPS in 1997, the
market has grown steadily and is on track to surpass
the $1 trillion mark in early 2013.
Why consider TIPS?
Unlike other fixed-income instruments, TIPS are designed
to protect the future purchasing power of the money
invested in them. The value of the TIPS principal is
adjusted daily to track changes in the CPI-U (non-seasonally
adjusted). Like nominal Treasury securities, which are not
adjusted for inflation, TIPS are issued with a stated fixed
rate (also known as the real coupon). However, the income
generated from a TIPS security is variable, equal to the
product of the real coupon and inflation-adjusted principal.
In contrast, nominal Treasuries provide a fixed rate of
income and non-variable principal.
The variable nature of TIPS income and principal makes
them effective hedges against the risk of future inflation,
as investors receive the full benefit of any rise in inflation
(see the first line of Exhibit 1). Expected inflation, on the
other hand, is inflation that is already priced into the bond
market, which is most commonly measured by a breakeven
rate. To calculate the breakeven rate for a given maturity,
subtract the real (inflation-adjusted) yield of a TIPS
security from the yield of a similar maturity nominal
Treasury security.
How do TIPS work?
TIPS prices react to changes in real yields in the same way
nominal Treasury prices react to changes in nominal yields.
In general, the prices of TIPS fall when real yields rise, and
rise when real yields fall (see top line of Exhibit 1). The
magnitude of this price movement can be approximated by
the TIPS’ duration, which measures the sensitivity of bond
prices to changes in interest rates.
Whether TIPS will outperform nominal Treasuries on a
relative basis depends on two primary factors (see the
bottom line calculation of Exhibit 1):
1. The difference between realized inflation and expected
inflation, as measured by the breakeven rate. If there is
unexpected inflation (i.e., inflation accrual is greater
than the breakeven rate), this will contribute positively
to TIPS’ performance vs. nominal Treasuries.
2. The change in the market’s expectation of inflation (i.e.,
breakeven rate) over the investment horizon. A rise in
expected inflation will contribute positively to TIPS’
performance relative to nominal Treasuries.
Therefore, when expected inflation rises or there is
unexpected inflation, the return on TIPS can benefit.
Exhibit 1: TIPS vs. nominal Treasury returns
TIPS Return1
1 Approximate
T 0 and T1
Inflation Accrual2
between times = 2 Approximately equal to the realized +
inflation between times T 0 and T 1
T 0 and T 1
TIPS Yield3
Yield at time T0
Nominal Tsy Yield b
Nominal Tsy Returnª
1 Approximate
3 TIPS
between times =
b Nominal
Tsy Yield at time T0
-
-
4 TIPS
TIPS Duration 4
Duration at time T 0
Nominal Tsy Duration c
c Nominal
time T0
Tsy Duration at
TIPS Return1 - Nominal Tsy
Inflation Accrual2
Breakeven Rate e
TIPS Duration f
= 2 Approximately equal to the realized - e Market’s expectation of inflation at + f Assuming the same TIPS and
Return a
inflation between times T 0 and T 1
time T0 between times T0 and T1
Nominal Tsy Duration at time T 0
Change in TIPS Yield 5
x 5 Change in yield of the TIPS security
between times T0 and T1
Change in Nominal Tsy Yield d
x d Change in yield of the Tsy security
between times T 0 and T1
Change in Breakeven Rateg
x g Change in market’s expectation of
inflation between times T 0 and T1
Source: Columbia Management Investment Advisers, LLC
The return on TIPS includes an inflation accrual amount. When this amount is higher than the breakeven rate, returns from TIPS may
benefit compared with those available from nominal Treasuries of the same duration.
When evaluating TIPS, investors should also take into
account the cost of inflation protection. As shown in
Exhibit 2, lower breakeven rates and higher TIPS yields
imply a lower cost for inflation protection, while higher
breakeven rates and lower TIPS yields suggest a
higher cost.
Exhibit 2: Cost of inflation protection with TIPS
Breakeven rate
Cost of inflation
protection with TIPS
Lower
Higher
Higher
Less
expensive
Mixed
Lower
Mixed
More
expensive
TIPS
yield
Source: Columbia Management Investment Advisers, LLC
A higher TIPS yield plus a lower breakeven rate means the
investor’s cost of inflation protection from TIPS is lower. In other
words, investors are giving up less in terms of yield in exchange
for the inflation protection when the breakeven rate is low and
the TIPS yield is high.
In order to illustrate this concept, Exhibit 3 plots monthly
five-year TIPS yields versus five-year breakeven rates for
each month from January 2002 through November 2012.
The lower yields available after the credit crisis reflect
aggressive monetary policy actions taken by the Federal
Reserve since 2008. On November 30, 2012, the five-year
TIPS yield was -1.51% with the five-year breakeven rate
at 2.02%. While on an absolute basis (y-axis), the cost of
inflation protection appears to be high relative to recent
history, the most recent breakeven rate is lower than the
median rate of 2.06% corresponding to the entire time
period. Therefore, today’s cost of inflation protection from
TIPS falls more into the “mixed” range in Exhibit 2 than the
“more expensive” category.
Exhibit 3: TIPS yields vs. breakeven rates
(January 2002–November 2012, monthly)
5-year TIPS yield (%)
Understanding the cost of inflation protection
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
5-year breakeven rate (%)
Pre-crisis and during crisis (January 02−June 09)
Post-crisis (July 09−November 12)
As of November 30, 2012 (most recent)
Sources: Bloomberg and Columbia Management Investment
Advisers, LLC
Today’s relationship between TIPS yields and breakeven rates
suggests the investor’s cost of inflation protection falls
somewhere between very high and very low.
3.0
What’s ahead for TIPS?
Looking ahead into 2013 and beyond, we’ve outlined two
possible macro scenarios that may cause investors to
benefit more from TIPS than nominal Treasuries.
Scenario 1: There is a favorable resolution of the fiscal
cliff of 2012 that helps sustain the recovery of the U.S.
economy into 2013. This would likely push bond yields
(both nominal and real) higher. Although this gradual move
to higher interest rates may negatively affect returns from
TIPS, a sustained recovery of the U.S. economy should
also push both headline inflation and breakeven rates
higher, causing nominal yields to rise faster than real
yields. This should benefit TIPS investors on a relative
basis as breakevens widen and TIPS accrue a higher rate
of inflation.
Scenario 2: Nominal rates stay below inflation rates for an
extended period of time. This would mean bond yields stay
expensive relative to inflation and TIPS should offer better
inflation protection than nominal Treasuries.
In our view, either of these scenarios is possible and offers
a solid case for investors concerned about inflation to look
to TIPS in 2013.
Important disclosures
The views expressed are as of January 2013, may change
as market or other conditions change, and may differ
from views expressed by other Columbia Management
Investment Advisers, LLC (CMIA) associates or affiliates.
Actual investments or investment decisions made by CMIA
and its affiliates, whether for its own account or on behalf
of clients, will not necessarily reflect the views expressed.
This information is not intended to provide investment
advice and does not account for individual investor
circumstances. Investment decisions should always be
made based on an investor’s specific financial needs,
objectives, goals, time horizon and risk tolerance. Asset
classes described may not be suitable for all investors.
Past performance does not guarantee future results and
no forecast should be considered a guarantee either.
Since economic and market conditions change frequently,
there can be no assurance that the trends described here
will continue or that the forecasts are accurate.
Securities products offered through Columbia Management
Investment Distributors, Inc., member FINRA. Advisory
services provided by Columbia Management Investment
Advisers, LLC.
Investment products are not federally or FDIC-insured,
are not deposits or obligations of, or guaranteed by any
financial institution, and involve investment risks including
possible loss of principal and fluctuation in value.
© 2013 Columbia Management Investment Advisers, LLC. All rights reserved.
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