TIPS Update: The Swiss Army knife of the bond market
Scott F. Grannis - Economist for Western Asset
TIPS are well into their fifth year of existence, and investors are finally beginning to take notice. They've proved to be valuable additions to any portfolio, beating the returns on both the S&P 500 and the Lehman Aggregate Bond Index in the three years ending April 30, 2001.
TIPS continue to offer a wealth of features not found in any other security: Guaranteed by the U.S. government. Better running yields than any Treasury. A guaranteed real rate of return linked to the CPI, the index most likely to overstate underlying inflation. Virtually zero correlation to equities. Low volatility. A worry-free inflation hedge that pays regular income (as opposed to real estate, which must be managed, and gold, which could sit idle for years). Deflation protection. A cheap embedded option. A hard landing hedge. Decent liquidity. In short, TIPS have become the Swiss Army knife of the bond market.
Competitive nominal yield. If CPI inflation continues at the pace of the past 12 months (2.9%), TIPS will yield substantially more than comparable-maturity Treasurys.
High real yield. The real yield on TIPS most likely understates the effective real yield an investor receives. That's because TIPS are indexed by the consumer price index, and the CPI has notoriously overstated inflation in the past. According to a broader measure of inflation, the personal consumption deflator, inflation at the consumer level has been at least 50 bps per year less than that registered by the CPI. If this relationship persists, it would imply that the effective real yield on 10- and 30-year TIPS currently could be as high as 3.7% and 3.9%, respectively. From an historical perspective, these levels are still reasonably attractive.
Low correlation to other asset classes. In addition to promising historically attractive real yields, the performance of TIPS since inception suggests that, as many had predicted, TIPS are a unique asset class. As the table below (chart 5) demonstrates, TIPS have demonstrated very low correlations to both equities and other fixed-income securities.
Low volatility. In addition to demonstrating very low correlation to other asset classes, TIPS have proved to be fairly stable as fixed-income assets go.
Inflation hedge. Like Treasurys, TIPS pay a semiannual coupon. But whereas the yield on Treasurys comes in the form of a fixed coupon, TIPS investors receive their yield through a combination of real coupons and the adjustment of their principal for inflation. For example, say the real coupon on day one is 3.25% and the CPI rises by 1.5% over the next 6 months. A TIPS investor would receive a coupon of $1.65 (.0325/2 * 1.015), and his principal would be adjusted upwards by $1.50, giving him an equivalent annualized yield of 6.4%. Since the yield a TIPS investor receives rises as inflation rises, TIPS should outperform Treasurys in a rising inflation environment. In addition, demand for TIPS might rise as inflation rose, driving TIPS prices higher and real yields lower, thus boosting holding period total returns.
Deflation protection. Deflation (negative inflation) would result in the downward adjustment of TIPS principal. For example, if inflation were -1% and the real coupon were 3%, the investor would receive a nominal yield of 2%. However, TIPS have some built-in deflation protection, because they will be redeemed by the Treasury at their initial principal value or their inflation-adjusted value, whichever is greater. Thus, in a deflationary environment, a TIPS investor willing to hold the bonds to maturity would be guaranteed to receive at minimum the stated real coupon yield, less the difference between the adjusted principal at purchase and the original par value.
Cheap embedded option. TIPS' ability to benefit should inflation rise yet not suffer symmetrically should inflation fall is in a sense equivalent to owning a Treasury bond with an embedded call option on inflation. Ordinarily, the value of the option would be reflected in a lower overall yield for TIPS vis a vis Treasurys. To date, however, investors have paid little or nothing for the option, because the effective yield on TIPS has exceeded the yield on comparable maturity Treasurys for the past three years, and the current expected nominal yield on TIPS exceeds that of comparable maturity Treasurys.
Hard landing hedge. TIPS could perform well in a hard landing scenario, even if, as usually happens in such circumstances, inflation falls significantly. That's because TIPS yields have demonstrated a strong correlation to both the level of real growth and to expectations of future Federal Reserve monetary policy. In a hard landing, lower GDP growth and the expectation of further Fed ease would likely trigger further declines in TIPS real yields. Even if inflation fell to zero, TIPS could still deliver their current 3.2% real yields, plus some price appreciation as the market level of real yields fell. The latter effect is not insignificant, given the high duration of TIPS prices for changes in real yields. For example, a 50 bps decline in real yields would equate to a price change in long TIPS of over 9%.
Liquidity. Ongoing issuance of TIPS since 1997 has created a market value today of almost $135 billion, representing just over 50% of the global inflation-indexed bond market. The size of each TIPS issue (with the sole exception of the recent 10-year issue) rivals that of all inflation-indexed bonds issued by the governments of Sweden, France, Canada and Australia.
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.
Scott F. Grannis - Economist for Western Asset
TIPS are well into their fifth year of existence, and investors are finally beginning to take notice. They've proved to be valuable additions to any portfolio, beating the returns on both the S&P 500 and the Lehman Aggregate Bond Index in the three years ending April 30, 2001.
TIPS continue to offer a wealth of features not found in any other security: Guaranteed by the U.S. government. Better running yields than any Treasury. A guaranteed real rate of return linked to the CPI, the index most likely to overstate underlying inflation. Virtually zero correlation to equities. Low volatility. A worry-free inflation hedge that pays regular income (as opposed to real estate, which must be managed, and gold, which could sit idle for years). Deflation protection. A cheap embedded option. A hard landing hedge. Decent liquidity. In short, TIPS have become the Swiss Army knife of the bond market.
Competitive nominal yield. If CPI inflation continues at the pace of the past 12 months (2.9%), TIPS will yield substantially more than comparable-maturity Treasurys.
High real yield. The real yield on TIPS most likely understates the effective real yield an investor receives. That's because TIPS are indexed by the consumer price index, and the CPI has notoriously overstated inflation in the past. According to a broader measure of inflation, the personal consumption deflator, inflation at the consumer level has been at least 50 bps per year less than that registered by the CPI. If this relationship persists, it would imply that the effective real yield on 10- and 30-year TIPS currently could be as high as 3.7% and 3.9%, respectively. From an historical perspective, these levels are still reasonably attractive.
Low correlation to other asset classes. In addition to promising historically attractive real yields, the performance of TIPS since inception suggests that, as many had predicted, TIPS are a unique asset class. As the table below (chart 5) demonstrates, TIPS have demonstrated very low correlations to both equities and other fixed-income securities.
Inflation hedge. Like Treasurys, TIPS pay a semiannual coupon. But whereas the yield on Treasurys comes in the form of a fixed coupon, TIPS investors receive their yield through a combination of real coupons and the adjustment of their principal for inflation. For example, say the real coupon on day one is 3.25% and the CPI rises by 1.5% over the next 6 months. A TIPS investor would receive a coupon of $1.65 (.0325/2 * 1.015), and his principal would be adjusted upwards by $1.50, giving him an equivalent annualized yield of 6.4%. Since the yield a TIPS investor receives rises as inflation rises, TIPS should outperform Treasurys in a rising inflation environment. In addition, demand for TIPS might rise as inflation rose, driving TIPS prices higher and real yields lower, thus boosting holding period total returns.
Deflation protection. Deflation (negative inflation) would result in the downward adjustment of TIPS principal. For example, if inflation were -1% and the real coupon were 3%, the investor would receive a nominal yield of 2%. However, TIPS have some built-in deflation protection, because they will be redeemed by the Treasury at their initial principal value or their inflation-adjusted value, whichever is greater. Thus, in a deflationary environment, a TIPS investor willing to hold the bonds to maturity would be guaranteed to receive at minimum the stated real coupon yield, less the difference between the adjusted principal at purchase and the original par value.
Hard landing hedge. TIPS could perform well in a hard landing scenario, even if, as usually happens in such circumstances, inflation falls significantly. That's because TIPS yields have demonstrated a strong correlation to both the level of real growth and to expectations of future Federal Reserve monetary policy. In a hard landing, lower GDP growth and the expectation of further Fed ease would likely trigger further declines in TIPS real yields. Even if inflation fell to zero, TIPS could still deliver their current 3.2% real yields, plus some price appreciation as the market level of real yields fell. The latter effect is not insignificant, given the high duration of TIPS prices for changes in real yields. For example, a 50 bps decline in real yields would equate to a price change in long TIPS of over 9%.
Liquidity. Ongoing issuance of TIPS since 1997 has created a market value today of almost $135 billion, representing just over 50% of the global inflation-indexed bond market. The size of each TIPS issue (with the sole exception of the recent 10-year issue) rivals that of all inflation-indexed bonds issued by the governments of Sweden, France, Canada and Australia.
To learn more about TIPS, please see TIPS Update: no longer a steal, but they still have appeal, TIPS Update: lower yields, but still attractive, TIPS and Strips, or TIPS-The Role of TIPS in Fixed-Income Portfolios
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.