Author's note: This article was released to CEF/ETF Income Laboratory members on May 2nd, 2022.
The iShares TIPS Bond ETF (NYSEARCA:TIP) is a treasury inflation-protected securities, TIPs for short, index ETF. TIPs are indexed against inflation, and see higher prices and coupon payments when inflation increases. TIPs are meant to outperform when inflation is high and rising, but have not performed all that well in the recent past, being down 6.4% YTD. Results have been disappointing, if slightly superior to that of bonds, equities, and most other relevant asset classes. TIP and other similar funds have performed worse than expected, so I thought to write an article explaining just why that was the case.
TIPs do see higher prices and coupon payments when inflation increases, but other factors matter too. Investors are selling bonds in anticipation of higher interest, and TIPs have not been spared. Investors also expect inflation to normalize relatively quickly, so demand for TIPs is lower than expected. Selling pressure and relatively low investor demand have caused TIPs prices to stagnate, even as inflation skyrockets. Insofar as inflation remains elevated TIP's long-term returns should be quite strong, but issues of market sentiment and investor demand are incredibly important in the short-term, and there are no guarantees that these will improve anytime soon.
Treasury Inflation-Protected Securities Overview and Analysis
TIP invests in treasury inflation-protected securities, or TIPs for short. This is a relatively niche asset class, so thought to start with a brief overview of how these function.
TIPs are bonds issued by the U.S. Federal Government, the most credit-worthy institution in the world. Credit risk is effectively nil, while dividends and interest rate payments are ultra-safe.
TIPs are protected against inflation, as their face value and coupon rate payments are indexed to the Consumer Price Index, or CPI, an inflation index, for positive values of said index. TIPs also technically pay interest, but interest rates have hovered around zero, even slightly negative, for quite a while now.
Let's explain the above with a quick example.
Say you invest $1,000 in TIPs at a 0% yield, meaning there are no interest rate payments, only an inflation hedge.
If inflation averages 8.5% for the year, the face value of your investment would increase by 8.5%. When the bond matures, you'll get paid $1,085, compared to an initial investment of $1,000. Total returns should equal $85, or 8.5% of your initial investment, equivalent to inflation. For regulatory and accounting reasons, most investment vehicles will reinvest your original $1,000 investment once the bond matures, and send you the $85 remainder as a dividend. Higher inflation would mean higher dividend payments, boosting total returns, and making TIPs a reasonably effective inflation hedge. In theory, at least.
TIPs long-term total returns should equal inflation plus interest. As interest rates are currently very low, we can safely ignore these, and so long-term total returns should roughly equal inflation. As per the BLS, inflation has averaged 2.3% for the past ten years, while TIP returns have averaged 2.5% for the same.
Long-term returns have been roughly equal to inflation, as expected. Returns have slightly outpaced inflation, mostly because interest rates were slightly higher in prior years.
Short-term returns are, however, an entirely different matter. TIP has been slightly down for the past twelve months, even as inflation skyrockets to 8.5%, the highest rate in decades. Performance is deteriorating too, with moderately negative returns YTD, even as inflation continues climbing.
To understand the above, let's revisit our example.
Say you invest $1,000 in TIPs at a 0% yield. If inflation increases to 8.5%, as has been the case these past twelve months, the government will pay you $1,085 once the TIPs matures. TIPs are long-term securities, with a minimum maturity of 5.0 years, and an average maturity of 7.8 years. Investors will receive those $1,085 in five to eight years. Investors are entitled to receive more or less nothing in interest, capital gains, or dividends before the bonds mature, hence the lackluster total returns of the past twelve months. TIP itself will make a series of dividend payments for an amount very roughly equivalent to 8.5% in the coming months, assuming inflation remains at those levels, but that is purely for accounting and regulatory reasons, and does not reflect underlying payment of dividends, interest, or cash-flow movements. Investors will receive a hefty payout in a couple of years, barring an unprecedented, catastrophic government default, but they are guaranteed more or less nothing while they wait.
Notwithstanding the above, in practice, TIPs tend to behave as if rising inflation immediately led to increased interest, capital gains, or dividends.
Let's revisit our example. Invest $1,000 in TIPs at a 0% yield. Inflation averages 8.5%, government promises to pay you $1,085 once the bond matures. Instead of waiting for the bond to mature, you sell the bond in the open market to interested investors. Investors will generally be willing to buy the bond for $1,085, as investors know that is the actual payout they'll receive once the bond matures, and that the U.S. Federal Government is an incredibly credit-worthy institution that will almost certainly make said payment. You sell the bond, and immediately book $85 in profits, without having to wait for the bond to mature. Importantly, you can book these profits without selling the bonds, as investments are valued at market prices, and the market (probably) values said bonds at $1,085, because that is what the government will pay for them.
The above is an incredibly simplified example. In practice, bond prices are dependent on many factors, including current and expectations of future interest rates, inflation, maturities, duration, convexity, etc. Higher inflation is important, but there are other factors too. Of these, two stand out.
First, we have expectations of increased interest rates, which are weighing down the price of most bonds. As mentioned previously, TIPs interest rates are currently hovering around zero. Investors are simply not all that interested in buying 0% yielding securities when they know interest rates are likely to increase in the coming months, courtesy of the Federal Reserve. Low investor demand means low asset prices, which means non-existent capital gains for TIPs investors, including TIP. Inflation matters, but interest rates matter too. In the long run, inflation should lead to strong returns for TIP investors, but short-term returns are an entirely different matter.
Second, we have expectations of normalizing inflation, which are leading to lackluster demand for TIPs and other inflation-hedge securities. Although many readers, subscribers, and investors have been concerned about inflation for months, some even years, most market participants believe inflation will soon normalize, although the situation is starting to change. As an example, consumers expected one-year ahead inflation of 3.4% in April 2021. One year later, actual inflation was equivalent to 8.5%, more than 5.0% ahead of expectations. Other time periods show broadly similar results, with realized inflation generally outpacing expected inflation. Inflation expectations have risen, but have lagged behind realized inflation for more than a year.
Inflation expectations are a key pricing component for TIPs, and one which can easily be measured. In general terms, TIPs should have equivalent long-term returns relative to treasuries, as both securities are issued by the Federal Government, and have similar credit risk. As TIPs are indexed to inflation, they should outperform when inflation is high. How high can be calculated using a metric called breakeven inflation rates, the specifics of which are outside the scope of this article. Breakeven inflation rates tend to track underlying inflation rates, as markets tend to be rational, and securities tend to be accurately priced, but there are exceptions. 5Y breakeven inflation rates currently stand at 3.3%, while annual inflation is running at 8.5%, a significant gap, and the largest in decades.
Investors are pricing TIPs with expectation of 3.3% inflation rates, while actual, realized inflation is running at more than twice that rate. This is a significant gap, and partly explains the subpar performance of TIPs during the past year or so. Inflation is at +8%, but investors are pricing TIPs as if inflation were running at 3%, hence the subpar performance of these securities. Importantly, long-term returns are not dependent on market prices, and should be quite strong if inflation remains elevated, and above current breakeven rates. It doesn't really matter what the market thinks once TIPs mature, and returns at maturity should be quite high if inflation remains elevated.
In general terms, I do believe that inflation will remain elevated for quite a while, due to elevated commodity prices, ongoing supply chain woes, elevated consumer demand, rapidly increasing labor costs, and the continued persistence of inflationary pressures. Under these conditions, TIPs are a broadly attractive asset class, especially in relation to other bonds. Markets mostly disagree, and seem to think inflation will normalize relatively quickly. They could very well be proven right in the future, although they have been wrong in the recent past.
As an aside, markets are starting to price TIPs more in-line with their fundamentals / current economic conditions. As an example, TIP was up by 1.2% in May 11th, outperforming most other asset classes, after April CPI data was released showing inflation remained stubbornly high. Markets are mostly rational.
Conclusion
TIP is a treasury inflation-protected securities index ETF. The fund is supposed to perform well when inflation is high, but has underperformed in the recent past, as interest rate and inflation expectations weigh down on bond asset prices. Insofar as inflation remains elevated TIP's long-term returns should be quite strong, recent weakness notwithstanding.
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