For investors of all ages, a fixed-income allocation can be an important part of a diversified portfolio—this is especially true for those nearing retirement. However, as inflation increases, rising consumer prices can seriously erode purchasing power as well as the value of portfolios, putting investors at serious risk of not meeting their long-term goals. This is why Treasury Inflation Protected Securities (TIPS) can be a valuable contribution to fixed income allocations in a portfolio.
How can a client’s portfolio benefit from an investment in TIPS?
TIPS are U.S. government-issued Treasury notes and bonds that come with inflation protection, backed by the full faith and credit of the United States with a principal value that is linked to inflation. Because TIPS are liquid obligations of the U.S. government, they tend to hold their value during times of market turbulence, at least better than other debt issues. All in all, TIPS provide uniquely defensive features, including diversification, to a portfolio of traditional financial assets, and can lower overall portfolio risk and potentially improve returns. This can be valuable since the historically low level of interest rates makes it difficult for current portfolios—ones without TIPS—to compensate investors for future inflation.
Who should consider investing in TIPS?
All investors might consider reallocating a portion of their fixed-income portfolio to TIPS, particularly if they are concerned about inflation and want to achieve the real, inflation-adjusted return that TIPS offer. TIPS are unique in the fixed-income market, in that they are linked to the prices of goods and services that people require in their everyday lives. Investors who are close to retirement, in particular, should consider holding a larger allocation to TIPS as a portion of their fixed income portfolio. An investor in her early 50s, for instance, still may have 15-18 years before retirement. Should inflation rise, her nominal bond portfolio may not keep pace with inflation, whereas a portfolio that is partially allocated to TIPS will ultimately help to preserve her purchasing power over time.
When do you invest in TIPS?
In any economic environment, TIPS offer the ability to protect purchasing power while mitigating risk. A key potential benefit of TIPS is the ability to hedge against unexpected inflation. The present economic climate may indicate a particularly good time to consider TIPS because of today’s two-pronged risks: weak growth abroad and rising inflation at home.
Tepid growth leaves the U.S. vulnerable to shocks from abroad, such as geo-political events or a sovereign default or banking system collapse in the Eurozone. The fragility of the global economy has contributed to caution by the Federal Reserve in raising interest rates, preferring to ensure that domestic growth will continue rather than focus on their inflation target rate. This is one of several signposts that point to the potential for higher levels of inflation and increased expectations of accelerating inflation. While inflation in the U.S. has been subdued for several years, TIPS have seen strong performance, in part because of a large decline in real interest rates and a surge in commodity prices. TIPS could continue to see strong performance based on the Federal Reserve’s ongoing use of an accommodative monetary policy amid a weak labor and housing market.
How can investors add value to a fixed-income portfolio through TIPS?
TIPS offer an attractive asset class return, or “Beta”, that differs from other liquid investment types. They also carry the potential for excess return opportunities, or “Alpha”. Although TIPS were introduced in 1997, the asset class is still not well understood by many investors. However, a skilled investment manager can seek out tactical opportunities to achieve gains based on the yield curve, the relative value of individual TIPS securities (supply and demand), as well as TIPS versus nominal Treasury securities. TIPS fund managers may identify and capitalize on distortions and mispricing across the inflation-linked universe, and also profit by being either over- or underexposed to changes in the CPI index based on their outlook for inflation. Other opportunities to add value over a TIPS benchmark may result from the U.S. Treasury auction calendar, the buying patterns of large TIPS investors, and the TIPS own structure.
Any fixed income sleeve of a portfolio can have added value through a TIPS investment, especially from a professionally managed mutual fund whose manager has a clear sense of inflation expectations and knows where the best opportunities may exist along the yield curve.
TIPS – Treasury Inflation Protected Securities (TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index (CPI), the commonly used measure of inflation.
CPI – Consumer Price Index (CPI) is a measure used to assess price changes associated with the cost of living. The return of Treasury Inflation Protected Securities is linked to the rate of U.S. Inflation as measured by the CPI.
Alpha – A measures a fund’s risk-adjusted performance independent of benchmark performance.
Beta – A measure of a fund’s volatility in comparison to a market benchmark: a Beta of less than 1 indicates a fund is less volatile than the market, while a Beta of greater than 1 indicates a fund is more volatile than the market.
The views and opinions expressed in this article are for informational purposes only, not for the purpose of providing investment advice, are those as of the date of the article and are subject to change at any time. The investment strategies discussed are not appropriate for every investor and investors should review with their advisors the appropriateness of any investment strategy. Manifold Fund Advisors, LLC makes no guarantees on the completeness or accuracy of information provided herein.
Investing involves risk. Investments in fixed income securities are subject to the risks associated with debt securities including credit, price, and interest rate risk. In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable. Before investing in any mutual fund, please carefully consider the investment objectives, risks, charges, and expenses.
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