We added TIPS (Treasury Inflation Protected Securities) to many of our client portfolios several years ago. We are now selling them out of client portfolios, as we no longer expect them to fulfill their intended purpose.
TIPS were created in the late 1990’s. Issued by the U.S. Treasury, they pay a low, fixed, nominal interest rate, plus each year the principal value is credited with an amount equal to the impact of inflation as measured by the Consumer Price Index. In essence, TIPS were designed as a way to lock in purchasing power, as the principal of the bond grew at the rate of inflation, and the interest payment provided some real, after-inflation, rate of return.
The Current Problem
The Federal Reserve implemented extraordinary measures to stimulate the economy in the wake of the financial crisis, and “real” interest rates have dropped below zero. These measures helped the U.S. economy avoid a deflationary spiral like Japan experienced over the past several years, but the current interest rate levels are not sustainable, as savers should expect a reward for foregoing immediate consumption, not the loss in purchasing power they are experiencing today.
As the Fed unwinds their measures, and the economy continues to recover, it is reasonable to expect interest rates to rise. One might expect some equilibrium state where short-term rates hover at or above the rate of inflation, and savers get a positive real rate of return.
In the current environment, the Fed has successfully pegged inflation expectations at about 2%, and the value of TIPS varies on changing expectations of Fed policy instead of inflation expectations. The markets try to guess when the Fed will allow real interest rates to rise back toward some equilibrium level. Since the change in value is not related to a change in inflation expectations, TIPS are not currently an effective hedge against inflation.
Compounding the problem is the fact that TIPS funds have a long average maturity, greater than the overall bond market. Since their change in value is now more sensitive to interest rate policy and changes in rates, they behave much like other long-term treasury bonds, and no longer provide the expected level of diversification in the bond portfolio.
TIPS no longer provide the portfolio benefit they were intended to provide. TIPS were originally expected to provide some protection from unexpected inflation. The Federal Reserve has acted aggressively since the financial crisis to stimulate the economy and avoid deflation. As a consequence of the Fed action, TIPS are now behaving like long-term treasury bonds, meaning their value is more sensitive to changes in interest rates. With inflation expectations seemingly under control, it does not make sense to endure the volatility of long-term treasury bond risk, particularly in the face of an expected rise in interest rates sometime in the future.