Credit Market Conviction: TIPS

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Includes: EDV, IEF, TIP
by: Eric Basmajian

Summary

TIPS have outperformed 10-year treasury notes.

TIPS outperform when inflation accelerates.

With oil falling and inflation expectations ticking lower, TIPS are starting to underperform.

Bonds or any fixed income stream of cash flow is typically negatively impacted by rising inflation. Treasury inflation-protected securities (TIPS) are a security designed to offset the negative impact of rising inflation.

TIPS act similar to treasury notes in some sense in that they are both bonds with a fixed interest rate, are backed by the US government and a promise to return principal upon maturity date. With a standard treasury note, upon maturity, you receive the par value of the bond in nominal terms, and depending on inflation or deflation, the par value may be higher or lower in real terms. TIPS are not impacted by inflation as the interest rate remains constant, but the par value is adjusted for inflation, measured by the Consumer Price Index [CPI]. Let's take a brief example below.

With a standard treasury bond, say a 10-year note with an interest rate of 3% and a par value of $1,000, an investor would receive $30 per year in interest payments and after 10 years, the $1,000 par value. The interest payment is fixed and the par value is fixed. If over the course of 10 years, inflation totals 20%, you would still only receive the par value of $1,000 and would take a loss in real terms on the principal. If inflation remains flat or declines (deflation), you would log gains in real terms.

TIPS act slightly different. First, TIPS typically carry a lower interest rate than an equal maturity treasury note, as the main function of TIPS is inflation protection rather than yield. If you bought 10-year TIPS with an interest rate of 1% and a par value of $1,000, you would receive the $10 per year in interest and at maturity, an inflation-adjusted principal. For example, if after 10 years, inflation totaled 20% based on the Consumer Price Index, at maturity you would receive $1,200 rather than $1,000 ($1,000 *1.2).

The interest rate payments on TIPS remain flat by each year, but the principal amount changes with inflation. After year 1, if inflation was 2%, the new principal would be $1,020 and your interest payments would be $10.20 per year (1% * $1,020).

TIPS carry a lower interest rate than an equal maturity treasury note due to the built-in inflation protection. During times when inflation is low, negative or non-existent, TIPS underperform regular treasury notes due to the lower yield. Periods with rising inflation hurt treasury notes due to the decline in real value, but TIPS, due to the inflation protect, hold their value.

The adjustments of principal are considered income for tax purposes. Investors may be subject to tax on "phantom income," with the gain in principal outweighing the coupons received.

The forward outlook on inflation is critical to the decision regarding investing in TIPS or treasury notes if you are allocating a portion of your investable portfolio to fixed income.

Lately, due to the surge in both actual measured inflation and future inflation expectations, TIPS have outperformed standard treasury notes. The iShares TIPS Bond ETF (TIP) is an ETF that tracks the performance of TIPS. The iShares TIPS Bond ETF has an effective duration of 7.5, most closely linked in terms of duration to the standard treasury ETF, iShares 7-10 Year Treasury Bond ETF (IEF), with an effective duration of 7.5 as well. For this analysis, the above ETFs will be used for comparison.

Inflation reached a low point in 2015, registering negative year-over-year readings before soaring to 2.77% in 2017. Inflation came off, down towards 1.7% before accelerating once again to 2.43% today.

We will take a look at the relative performance of TIPS and standard treasury notes below.

Inflation Has Been On The Rise:

Source: YCharts, EPB Macro Research

Starting in June 2017, around the time when inflation bottomed near 1.7%, was the start of a streak of outperformance for TIP relative to IEF.

During periods of accelerating inflation, TIPS will outperform standard treasury notes. Keep in mind, it is not the nominal level of inflation that determines the relative performance between securities but rather the rate of change in inflation from the time of purchase to the time of sale or maturity.

TIPS vs. Treasury Note Performance (1 Year):

Source: YCharts, EPB Macro Research

To assess whether it would be best to purchase TIPS or standard treasuries from this point would require information regarding the current rate of inflation and the market expectations for future inflation as well as our own analysis surrounding future inflation trends.

If inflation is expected to rise above the current rate of long-term inflation, TIPS would be a better choice. Should we be near the peak in inflation, around 2.43%, and the rate falls over the next several years, standard treasury notes will outperform TIPS and make for a better investment. Let's take a look.

Currently, the last reading on the Consumer Price Index was 2.43%. The month-to-month readings in the Consumer Price Index can be volatile and a 12-month average is a better measure of trailing inflation. Over the past one year, inflation has averaged 2.08%. Over the past several weeks, with oil prices (USO) declining sharply, investor expectations for future inflation have softened, and thus, standard treasury notes have been outperforming TIPS.

TIPS vs. Treasury Note Performance (2 Weeks):

Source: YCharts, EPB Macro Research

The 10-year breakeven inflation rate, or the market expectation for annual inflation over the next 10 years, has dropped from almost 2.2% down to 2.09%. Currently, the trailing inflation rate and the forward 10-year inflation expectation are nearly exactly the same.

10-Year Breakeven Inflation Rate (Inflation Expectations):

Source: YCharts, EPB Macro Research

If an investor holds the opinion that inflation will remain elevated and average above 2% for the next 10 years, based on the Consumer Price Index, TIPS will likely be a better investment. If we have reached peak inflation and the next several years bring a CPI reading that is lower than 2% on average, expectations will change and standard treasury notes will perform better than TIPS.

CPI Year over Year (12-Month Average):

Source: YCharts, EPB Macro Research

Inflation is a terrible measure of economic activity as it adjusts last in the money, income, price spiral made popular by economist Milton Friedman; the chart above is evidence of that.

I am in the latter camp that we are near a cyclical peak in inflation that began at the beginning of 2016 when oil prices bottomed.

With inflation set to stay flat or decline over the next several months/years, I do not anticipate the next 10 years bringing average inflation over 2%, again, based on the Consumer Price Index calculation.

There was a fantastic time to buy TIPS during 2016 for the coming acceleration in inflation. With inflation set to cool as oil prices have come back from the peak, it is time to switch from TIPS to standard treasuries. I, however, do not like 10-year notes or IEF due to the position near the 'belly of the yield curve' that is subject to pressure from Quantitative Tightening. I am increasing allocation to long-duration bonds (EDV) to benefit from a continuation of a flattening yield curve.

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Disclosure: I am/we are long EDV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.