March 15th, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
TIPS, Inflation and Your Portfolio
- The specter of rising inflation rates has some investors questioning how to best allocate their assets to protect their long-term purchasing power.
- Treasury Inflation-Protected Securities (TIPS) are an instrument whose principal is adjusted based on changes in the Consumer Price Index (CPI), a key measure of inflation.
- Gerstein Fisher conducted research over several economic cycles to analyze the performance of TIPS relative to several other asset classes.
- Our findings: TIPS do not provide meaningful inflation-hedging advantages over other asset classes such as equities, REITs, and commodities.
- Additionally, given that income from both the inflation adjustment to principal and interest payments of TIPS are subject to ordinary income tax rates, they are notably tax-inefficient when held in taxable accounts.
Following an extended period of hibernation, there are signs that inflation is stirring and finding its feet again. Consumer price gains have perked up in recent months. Inflation expectations, as measured in the Treasury market, have also crept higher due in part to the expansionary fiscal and economic policies espoused by the Trump Administration. Investing to maintain or increase a portfolio’s purchasing power (a critical goal for investors) in times of higher inflation requires some careful thinking about asset allocation. With this in mind, we thought it would be timely to look back and apply the lens of history to compare the portfolio inflation-hedging merits of Treasury Inflation-Protected Securities (TIPS) with those of several other asset classes.
Inflation: Past, Present, and Future
Although inflation expectations have increased since President Trump’s election in November 2016, there was already some inflationary pressure building in the economy. The US Consumer Price Index (CPI), as measured by the Bureau of Labor Statistics, increased by 2.1% in 2016 (compared to less than 1% in both 2014 and 2015), helped along by falling unemployment and rising prices of energy and other natural resources. The January 2017 CPI figure was up 2.5% from the year-earlier number.
The market’s expectation for higher inflation rates during the Trump Administration hinges on a few factors. The Administration is seeking to provide enough stimulus through a combination of tax cuts (corporate and individual), deregulation and spending increases to boost US economic growth to 3% or higher, compared to an average of just 2% during the nearly eight years of recovery since the Great Recession ended in mid-2009. In addition, substantial proposed changes in trade policy aimed at maintaining and returning manufacturing production and jobs to the US through tariffs, revised taxes, or other means could add to inflationary pressure through higher import prices if accompanied by little or no reduction in domestic production costs or further US dollar appreciation.
Markets have bought into a reflation trade since President Trump’s election. For example, signaling higher expected inflation, yields on 10-year Treasuries rose 70 basis points from November 8, 2016 to March 10, 2017 (to 2.57%), and the 10-year breakeven inflation rate (for Treasuries vs. inflation-linked Treasuries), a measure of expected inflation, increased by 30 basis points to 2.02% during the same time frame.
How high an inflation rate will be realized in the coming years is anybody’s guess, but a look back at history may be instructive. Inflation has been unusually low by historic standards in recent years (see Exhibit 1), averaging just 1.2% from June 2012 to January 2017. From 2006 to 2012, a period that included the financial crisis of 2008-2009, the inflation rate averaged 2.3% and was much more volatile. For a couple of decades prior to that (see Exhibit 2), inflation averaged 3%, which is very close to the 2.9% long-term average from January 1926 to January 2017. Bursts of inflation are often episodic and difficult to forecast, but, given more inflation from economic growth and trade policies, a return to a 3% rate—the historic norm—would not be an unreasonable scenario.
The Nature of TIPS
With that context, let’s turn now to TIPS and the question of whether these securities–if one assumes that we’re entering an environment of higher inflation– make an attractive hedge against rising prices in a diversified portfolio. As the name implies, inflation-linked bonds provide a higher return when inflation is higher. The principal of a TIPS bond increases with inflation and decreases with deflation, as measured by the Consumer Price Index(CPI). When a TIPS bond matures, the investor earns the adjusted or original principal, whichever is greater. Due to that protection against inflation, TIPS typically trade at a discount to non-inflation-linked Treasury bonds (see Exhibit 3). For example, on March 10, 2017 the yields on 10-Year Treasuries and 10-Year TIPS were 2.57% and 0.55%, respectively, implying a 10-year breakeven inflation rate of 2.02%, which approaches the actual level of inflation.
We’ve discussed above why we think we may see more inflationary pressures in the US economy, but whether those pressures are ultimately manifested as realized inflation depends on factors such as the monetary policy response to them from the Federal Reserve Board. In other words, although inflation-linked bonds appear more interesting in light of increasing inflation pressure, they are really only compelling if you believe that realized inflation will be higher than the current (~2%) breakeven inflation rate.
TIPS vs. Other Assets
For our study, we compared the historical performance of TIPS and other possible inflation-fighting assets during periods of economic expansion and recession. First, let’s describe our methodology. The National Bureau of Economic Research (NBER) identified seven recessions from 1970 to 2016. To capture various cycles, we broke this 47-year period into four different segments: recession (as defined by the NBER), pre-recession (12 months prior to recession), post-recession (12 months after recession), and expansion, which we define as any period from 1970 to 2016 that is not in one of the three other periods. Using these definitions, we count 89 months of recession and 332 months of expansion during the time frame.
During all four economic cycles, we studied the performance of six asset classes: TIPS, Treasury bills, commodities (S&P GSCI Index), US stocks (S&P 500 Index), international stocks (MSCI EAFE Index), and real estate (DJ REIT Index). Exhibits 4 and 5 report the performance of all six asset classes during recessionary and expansionary periods. Note that each of the seven dates represents the end of a recession.
Not surprisingly, since interest rates typically decline during recessions, the star performer during economic slumps was T-bills, which on average returned 12.69% (annualized). TIPS performed somewhat less well (9.44%) and, on average, stocks either lost money (international-developed) or barely broke even (US). The performance of commodities and REITs landed in between that of equities and Treasuries.
Expansionary periods generally coincide with rising rates of inflation. As Exhibit 5 demonstrates, the average annualized return for TIPS across all expansions was 6.64%, compared to 5.59% for T-Bills. At first glance, the narrowness of TIPS’ return premium may seem surprising, but it is important to note that TIPS, though they are indexed to CPI, are still exposed to interest-rate risk—i.e., inflation and interest rates are not perfectly correlated. Thus, if nominal yields rise due to inflation, TIPS are protected, as the principal is adjusted upwards along with inflation; but if nominal yields rise owing to rising real yields (inflation-adjusted yields), the value of TIPS will decrease.
What comes through loud and clear during the periods of expansion is that, on average, “risky assets” such as stocks (US and foreign), REITs and commodities outperform TIPS in dramatic fashion. For instance, the annualized returns of the S&P 500 and MSCI EAFE indexes, respectively, were more than two and three times those of TIPS. Finally, it is worth noting that TIPS are tax-inefficient when held in a taxable account since income from both the inflation adjustment to principal and interest payments are subject to ordinary income tax rates, which would erode much of the advantage of TIPS over T-Bills in a taxable account.
Tale of the Portfolios
For the final step of our analysis, we created four separate portfolios (Exhibit 6), with and without TIPS, and simulated results (Exhibit 7) through expansionary and recessionary periods going back to 1970. This provides a sense of how inflation-protection instruments perform in diversified portfolios in times of recession and expansion.
What we conclude from studying the results of this simulation is that TIPS do not really provide inflation-hedging advantages over other asset classes such as equities, REITs, and commodities (and during recessionary periods TIPS perform quite poorly relative to Treasuries). In addition, inflation-protected bonds are notably tax-inefficient when held in taxable accounts.
We can’t predict the trajectory of future price increases, but the market seems to be anticipating higher inflation down the road. Looking back historically at expansionary economic periods, we compared the performance of TIPS with that of other inflation-protecting asset classes in diversified portfolios. We did not find TIPS compelling, since equities, commodities, and REITs provided as much or more inflation benefit than TIPS, and with less of a tax disadvantage.