When inflation is elevated, Treasury Inflation-Protected Securities (TIPS) can be an appealing option for bond investors, particularly at the shorter end of the yield curve.
Unlike traditional Treasury bonds, TIPS are designed to protect investors against inflation. Their principal value adjusts with changes in the Consumer Price Index (CPI), while the stated interest rate represents a return above inflation. This means that when real yields are positive, investors can earn a return above whatever inflation ultimately turns out to be.
That can be particularly attractive when real yields are meaningfully positive. For much of the period following the 2008 financial crisis, real yields on shorter-term TIPS were actually negative. Investors were effectively accepting a negative real return in exchange for inflation protection. When real yields become positive, the equation becomes considerably more appealing.
Where TIPS Can Be Most Attractive
The 5- to 10-year range can offer an attractive balance between inflation protection and interest-rate risk.
Shorter maturities limit duration risk if real yields rise further, while longer maturities allow investors to lock in positive real returns for a longer period.
Investors should also pay attention to the breakeven inflation rate. This represents the inflation rate at which an investor would expect to earn roughly the same return from a TIPS investment as from a comparable traditional Treasury bond.
If you believe actual inflation will exceed the market’s implied breakeven rate, TIPS may be relatively attractive compared with conventional Treasuries.
The opportunity is particularly interesting when inflation remains elevated but the bond market appears to be pricing in a relatively quick return to lower inflation.
Remember the Tax Implications
TIPS are generally best suited to tax-advantaged accounts such as IRAs and retirement plans.
One reason is the potential for phantom income. When the principal value of a TIPS increases because of an inflation adjustment, that increase can be taxable even though the investor has not actually received the additional principal in cash.
For investors considering TIPS, the potential inflation protection should therefore be evaluated alongside the investment’s maturity, real yield, interest-rate risk, and tax treatment.