TIPS and the Nature of Inflation Protection
by Daniel W. Wallick and Jill Marshall
The Federal Reserve Board’s aggressive and accommodative measures to bring down interest rates, thereby stimulating the economy, continue to raise concerns about future inflation, even while many feared the economy could be heading into a prolonged deflationary period. In turn, the prospect of higher inflation has sparked considerable investor interest in Treasury Inflation-Protected Securitiesand other inflation-hedging assets.
Cash flow into TIPS this year was $7 billion though September 30, 2010, as compared to $27 billion and $13 billion for full years 2009 and 2008, respectively. The significant increase in 2009 cash flow was in part due to investors’ flight to safety. Total net assets of $104.5 billion as of September 30, 2010, clearly indicate that the TIPS market has experienced significant growth since the government’s first inflation-protected bond was issued in January 1997.
In this article
- Mechanics of TIPS and the Break-Even Inflation Rate
- Hypothetical Performance of TIPS Versus Treasuries
- Actual Performance: 2000–2010
- Investment Implications
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An important reminder for investors seeking to protect a portfolio’s purchasing power is the fact that the total return on a TIPS fund is a function of both actual trailing inflation and the bond market’s expectation regarding future inflation. Consequently, while a TIPS portfolio does adjust an investor’s principal investment by the actual trailing inflation rate, changes in inflation expectations can produce subpar or negative total returns even when actual inflation is positive. Yet, regardless of the direction inflation takes in the future, some bond investors may benefit from knowing that they have some degree of inflation protection.
To help investors assess the role of TIPS in a broader portfolio, we review the mechanics of TIPS, the concept of the break-even inflation rate, and the nature of the inflation protection provided by a TIPS fund. We then compare the absolute performance of a broad TIPS portfolio over the past 10 years with the actual inflation rate, and the relative performance of a TIPS portfolio compared with that of a portfolio of nominal U.S. Treasury bonds. Finally, we frame a discussion about an appropriate allocation to TIPS as part of a taxable bond portfolio by summarizing the relative market capitalization of the TIPS market.
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Jill Marshall is an investment analyst with the Vanguard Investment Strategy Group.