Pro TIPS: Take into account inflation-protected bonds

TIPS performance is driven by both interest rate risk and inflation expectations—and this can result in unexpected scenarios, such as TIPS posting a negative performance in a high-inflation environment. Moreover, sometimes the better strategy is not to own TIPS outright, but instead through a hedged position that isolates your exposure to only the “breakeven inflation” risk inherent to TIPS.

Like much of the bond market, the yield earned by TIPS investors, known as real yield, is at its most attractive levels in over a decade. A long-term allocation to TIPS can be helpful for investors who are more sensitive to unexpected inflation shocks and want to take advantage of these attractive real yield valuations. Our team added TIPS breakevens to our active government funds and some of our multi-sector portfolios.

After a consistent downtrend in 2023, inflation has been stabilizing at levels above the Fed’s target. Over the first quarter of 2024, the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) Price Index posted larger-than-expected gains.

Inflation has been sticky recently because of the tight labor market, elevated shelter costs, and a reversal in goods disinflation, which primarily drove last year’s downtrend.

Near term, we see potential for further inflation volatility. Long term, we expect inflation to moderate to the Federal Reserve’s target as tighter monetary policy takes effect.

You probably want your portfolio to be protected from adverse outcomes and, if you can, capitalize on inflation-related market moves now. Just remember that TIPS’ performance is not always straightforward.

• TIPS involve interest rate risk: Just like any other type of bond, buying TIPS introduces interest rate risk to a portfolio. If rates rise and inflation expectations are steady (or also rise, but not as much as yields), real yields also rise, potentially leading to negative returns in TIPS. The negative return impact from rising yields can more than offset the positive impact from the inflation adjustment, as was the case in 2022.

• TIPS outperform when inflation exceeds expectations: The real yield earned through owning TIPS is lower than the yield earned by a nominal Treasury investor because of the assumption that inflation will occur and compensate the TIPS investor. If this assumed level of inflation priced into TIPS, known as “breakeven inflation,” occurred over the life of the bond, nominal Treasuries and comparable TIPS would have the same return. TIPS will outperform nominal Treasuries when actual inflation exceeds expected inflation and underperform nominals when actual inflation is lower than expected inflation. 

Remembering these factors can help you avoid the surprise some investors experienced when they allocated to TIPS in 2021 as inflation began to rise. Rising interest rates in 2022 hurt TIPS like they did all bonds; TIPS returned –11.85% that year, better than U.S. Treasuries (–12.46%) but still a negative total return.¹

The upside risk to inflation as well as the fact that inflation tends to be seasonally higher in the first half of the year created an opportunity in TIPS. Our team added exposure across our active government funds and some of our multi-sector portfolios.

However, we hedged the duration risk of these positions to leave only exposure to breakeven risk—the risk that inflation expectations change in the near term. Breakeven trades can be set up by buying TIPS and selling a nominal Treasury or Treasury derivative, or vice versa, depending on your outlook for inflation. This positioning means our portfolios can benefit from higher-than-expected inflation while being hedged from the potential impact of rising rates. 

Allocating to TIPS requires skill. It’s difficult to predict the path of inflation and interest rates. Partnering with an active manager can allow your portfolio to benefit from opportunities the market presents without being exposed to unintended risks.

Our expertise spans the fixed income market, which helps us in identifying the best opportunities across bond sectors at any given time. Experience, tools, and insight, as well as the flexibility active strategies provide, allow us to isolate and exploit precise risk factors—such as the breakeven inflation risk—to aim for consistent outperformance over time. 

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