Treasury inflation-protected securities (TIPS) might not receive the recognition they deserve, but they offer investors a direct avenue to safeguard their investments against inflation. Despite the complexities associated with TIPS, it's worth delving into their details since their yields are currently impressive and they serve as a viable alternative to regular Treasury bonds.
Understanding TIPS Yields
TIPS yields comprise two components: an inflation adjustment, which mirrors the consumer price index, and a real yield, which represents a bonus above the inflation rate. At present, the real yield stands at around 2.5%, its highest level in 15 years. Considering that inflation is running at over 3%, certain TIPS are now offering yields of approximately 6%. However, the actual return on TIPS, which can have maturities of up to 30 years, will depend on future inflation rates.
The Appeal of TIPS
Rob Arnott, the founder of Research Associates, highlights the increasing allure of TIPS due to their rising real yields. He states, "The real yield is getting back to abnormally high levels. Looking at 10- and 30-year TIPS and 10- and 30-year Treasuries, the easy choice is to own TIPS. Inflation is more of a risk than the markets give it credit for."
Break-Even Inflation Rate
The break-even inflation rate between regular Treasuries and TIPS currently hovers around 2.35% for the next five, 10, and 30 years. Hence, if inflation surpasses this threshold, investors will fare better with TIPS than with regular Treasuries.
Uncertainty and Inflation
While the markets anticipate that the Federal Reserve will succeed in lowering inflation to its 2% target, the reality remains different. Over the past 1.5 years, inflation has held steady at over 3.5%, largely due to factors such as a tight labor market. Consequently, the potential for elevated inflation persists.
In the past two years, TIPS bond prices, like regular Treasuries, have experienced a decline. As a result, some investors have grown skeptical of this $2 trillion sector. Although TIPS holders have benefited from higher inflation, the appreciation in yields has contributed to a decrease in bond value, given the shift from negative 1% real yields earlier in 2022. Nevertheless, real yields may be approaching their peak, even if Treasury yields rise.
Sources: Bloomberg, CEF Connect, company reports
Real Yields and Investing in TIPS
In the early 2000s, real yields reached a high of nearly 3%. Some experts believe that this may be the ceiling for real yields, as it attracts investors who typically don't invest heavily in bonds, such as pension funds.
The Path to Market Exposure
One of the most effective ways to gain exposure to the market is through low-fee exchange-traded funds (ETFs). These funds provide an opportunity for investors to participate directly in the Treasury Inflation-Protected Securities (TIPS) market. Investors can purchase TIPS either directly from the Treasury or through banks and brokerage firms.
Notable ETFs in this space include the $52 billion Vanguard Short-Term Inflation-Protected Securities (VTIP) and the iShares 0-5 Year TIPS Bond (STIP). VTIP is the largest TIPS ETF, while STIP focuses on shorter-maturity TIPS. Both ETFs have delivered a return of about 2% this year. On the other hand, the iShares TIPS Bond (TIP) and Pimco 15+ Year U.S. TIPS (LTPZ) ETFs primarily hold longer-maturity TIPS. The Pimco fund has experienced an 8% decline, but it has the potential for significant gains if real yields decrease due to its sensitivity to rate changes.
For investors seeking alternatives, the Western Asset Inflation-Linked Opportunities & Income closed-end fund (WIW) presents an interesting option. With approximately 80% of its assets allocated to TIPS and other inflation-linked bonds, the fund offers a yield of nearly 9% (reflecting leverage) and trades at a 15% discount to its net asset value.
Tax Considerations for TIPS
When it comes to taxes, TIPS can be complicated. The inflation component of the bond's interest rate is added to the principal value, which results in phantom income subject to income taxes. Therefore, individual TIPS may be more suitable for tax-advantaged accounts.
Advantages of ETFs
Compared to direct investment in TIPS, ETFs provide several advantages. They offer better liquidity, monthly income (as opposed to semiannual income with TIPS), and eliminate phantom income. Moreover, ETFs have low fees, with Vanguard and shorter-dated iShares ETFs charging less than 0.05% annually, while longer-dated iShares and Pimco ETFs charge approximately 0.2%.
It's crucial for investors to evaluate their investment options carefully and consider their specific circumstances before making any decisions.