Inflation Is Way Up, Why Aren’t TIPS?

Inflation is higher than it’s been since the early 80’s, so why aren’t TIPS (Treasury Inflation-Protected Securities) up too? After all, TIPS were created for the sole purpose of combating inflation.

Here’s a look at the recent performance of TIPS.

Year to date, TIPS are down -4.45%.

Even looking back over the previous 12 months they are in negative territory.

How TIPS Work

Traditional bonds offer a fixed, periodic interest rate through their maturity, at which point the owner is paid back the face value of the security. To a large degree, yields on traditional bonds factor in expected inflation. The problem is that over time, inflation will still eat away at the value of that bond. That’s especially an issue for long term bonds.

TIPS supposedly solve the inflation problem by adjusting the amount due to investors based on changes in the consumer price index. This means that investors get paid more as inflation rises. If the CPI climbs 5%, the amount investors receive will also rise by 5%.

So, why aren’t TIPS hedging against the highest inflation levels we’ve seen in decades?

In a nutshell, investors are getting a lesson in the dynamics of the Treasury Inflation-Protected Securities market. Just because inflation is high and rising doesn’t mean that a TIPS fund will be making money. It can easily be the opposite. Often what matters more is what is expected to happen with inflation in the months, quarters, and years ahead.

This is an area that seems so simple and obvious. If inflation is going up, just buy TIPS and make some money on the hedge. The problem is that the market had anticipated that would happen and now TIPS investors are late to the party.

While inflation readings have been getting hotter, investors are also expecting the Federal Reserve to take more aggressive action to put out the fire. So, with TIPS in the red now, the market isn’t reacting to the current inflation news, it’s reacting to expectations of strength by the Fed.

Other Headwinds for TIPS

Another hit for TIPS has been the overall rise in interest rates. At the end of the day, TIPS are still bonds.

Despite the inflation protection, an overall rise in the level of interest rates will still feed through to the TIPS market, putting downward pressure on the bond prices.

Conclusion

While the mechanics of TIPS work exactly as they should, their overall performance is driven more by “expectations” of inflation, rather than current levels of inflation.

This can lead to a great deal of frustration by investors – and rightly so. There is nothing wrong with having some TIPS exposure to diversify a bond portfolio, but it’s important to understand that the performance may not correlate directly with inflation.

The performance catalyst of a particular asset class is rarely just one thing. It’s usually multi-faceted and not always obvious. Thus is the case with TIPS.