With reported inflation showing signs of recovery, this could be an opportunity for investors with fixed income investments to swap some of their high-grade (nominal) bonds for TIPS—Treasury Inflation Protected Securities.
The financial press has seen signs of inflation on the horizon, but not so much the financial markets. Some recent headlines reveal the growing trend:
Like other bonds, TIPS pay fixed yields. However since the principal value of TIPS rises in tandem with the Consumer Price Index (CPI), they can provide an effective choice for savers seeking protection from inflation within the U.S. public bond market.
As many forecasts have been predicting, the days of zero inflation reports may be over. The Bureau of Labor Statistics’ release of the Consumer Price Index (CPI) for January provided evidence to that end:
The year-over-year increase in “full” CPI to a 1.4% rate stands in stark contrast to the first ten months of 2015, when the rates ranged between -0.2% and +0.2%. But for anyone who was following the “core” inflation rate of CPI—which has been at or above 1.6% year-over-year since mid-2011 (excluding food and energy)—this uptick in headline inflation came as no surprise (Graph 1).
Graph 1: “Full” CPI compared to “core” CPI
Source: Federal Reserve Bank of St. Louis FRED database1
The rate of increase for full CPI has been suppressed by the dramatic decline in wholesale energy prices, led by crude oil’s 69% plunge between July 2014 and January 2016,2 but the core inflation rate has not. With crude oil’s rate of decline having slowed recently, the CPI has had a chance to start catching up with the core rate.
There is advantage in buying TIPS before the “full” inflation rate of CPI catches up with the “core” rate, especially since traditional fixed-income investments may not provide the return investors need during periods of higher inflation.
With the spread between TIPS “real” yields and nominal Treasury yields trading near post-recession lows, there is an investment opportunity while inflation trails behind the core CPI average. Ten-year TIPS break-even rates (returns over inflation) have dipped as low as 1.2% this year, which the core average has surpassed at 1.6%.
With a break-even rate that low, a 10-year TIPS security would only need CPI inflation to match that break-even rate to produce the same return as a ten-year nominal bond. And if inflation averages more than the break-even rate, TIPS can outperform a fixed-rate bond.
Source: Federal Reserve Bank of St. Louis FRED database3
With reported rise in inflation showing signs of recovery and the Federal Reserve committed to a policy rate of inflation well above both the breakeven rate and the recent realized inflation rate, this could be an opportunity for investors in balanced portfolios to swap some of their nominal bonds for inflation-protected ones—TIPS.
1US. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items [CPIAUCNS], All Items Less Food and Energy [CPILFENS], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/CPIAUCNS, March 1, 2016.
2Source for crude oil prices: Federal Reserve Bank of St. Louis FRED database.
3Federal Reserve Bank of St. Louis, 10-year Breakeven Inflation Rate [T10YIEM], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/T10YIEM, March 1, 2016.
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.
Barclays Capital U.S. Treasury Inflation Protected Securities (TIPS) Index consists of Treasury inflation protected securities with a remaining maturity of one year or more. The index is not available for purchase.
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