Holders of regular bonds know that inflation and rising interest rates cause bond values to decline. But there is another option: Treasury Inflation-Protected Securities (TIPS) are bonds whose value increases as inflation increases.
I-Bonds vs. Inflation-Protected Bonds
There are two main types of TIPS: I-Bonds and inflation-protected bonds. I-Bonds are for individual investors, issued by the Treasury Department, and their yields adjust upward or downward to reflect changes in the Consumer Price Index (CPI). Inflation-protected bonds, such as TIPS, are similar, but the inflation adjustment impacts the principal level and not the bond’s yield.
While there are no funds composed of I-Bonds, there are a number of funds that focus on inflation-protected bonds.
- Vanguard Inflation-Protected Securities (VIPSX): A plain-vanilla TIPS exposure fund with very low fees.
- PIMCO Real Return Fund (PRTNX): A PIMCO-managed fund that is exposed to U.S. TIPS and invests 20% outside of the U.S. in international TIPS.
- Harbor Real Return (HARRX): A PIMCO-managed fund that employs a broader toolkit for investors. HARRX encompasses non-U.S. inflation-protected bonds and the use of forward contracts to obtain TIPS exposure.
- Principal Inflation Protection Fund (PITAX): The fund provides exposure to TIPS of varying maturities issued by the U.S. and foreign nations. Also, this fund invests in corporate TIPS issued by U.S. and non-U.S. companies.
When to Buy TIPS
TIPS become more valuable when the CPI rises. The CPI is composed of a basket of goods that are weighted by their importance to consumers.
According to the BLS report, the August 2015 weights of the major goods are:
- Food: 14%
- Energy: 8%
- Commodities less food and energy: 19%
- Apparel: 3%
- New Vehicles: 3%
- Shelter: 32%
- Medical Care: 6%
- Transportation: 6%
As you can see, goods related to commodities (e.g. energy, agricultural, softs) and real estate are the major influences on the CPI. Recently, commodities have hit 40-year lows which have driven the value of the CPI down.
The CPI is currently hovering around unchanged year over year. The stated inflation target for the Federal Reserve is 2%, but because of large declines in food and energy prices the CPI is far below that target.
The Bottom Line
As the CPI increases, TIPS become more valuable and vice-versa. Energy and food items are the major drivers of the CPI, and these are dependent upon the health of the global economy. As the economy has slowed down, central banks around the world have utilized quantitative easing strategies in order to restart it. Quantitative easing produces inflation and in theory should increase the value of TIPS assets. Additionally, global economies that are undergoing rapid currency depreciation will experience rapid inflation. These economies are more risky, however, their TIPS assets will provide outsized returns.
Investors should rotate into TIPS and other inflation-hedged assets when quantitative easing occurs and when inflation shows potential to get out of hand. Investors should also be aware that quantitative easing inflates the stock market, but that the stock market is subject to inflationary value pressures, which reduce real returns.
Image courtesy of renjith krishnan at FreeDigitalPhotos.net
