Last week, inflation was reported at a 40-year high, posting a much stronger-than-expected rise. But inflation-protected bond funds racked up losses, extending declines posted since the start of the year. What gives?
In a nutshell, investors are getting a lesson in the dynamics of the U.S. 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 where it looks simple, and obvious: why not just buy them if inflation is going up?” says Eric Jacobson, fixed income strategist in Morningstar’s manager research group. “The answer is that the market had anticipated that would happen.”
Currently, while inflation readings have been getting hotter, investors are also expecting the Federal Reserve to take more aggressive action to put out the fire. “With TIPS selling off, the market isn’t reacting to the inflation news, it’s reacting to expectations of strength by the Fed,” says Jacobson.
This is playing out in negative returns on TIPS funds so far in 2022. The iShares TIPS Bond ETF (TIP) is down 4.5% so far this year, having returned 5.7% in 2021.
Among actively managed TIPS mutual funds in the U.S., one of the largest, the American Funds Inflation Linked Bond Fund (BFIAX), is down 3.7% in 2022 after a 3.8% return last year.
There is still more to the story for investors to understand in order to make best use of TIPS in a portfolio, including understanding where TIPS are saying about the level of expected inflation, “real yields” and the exposure to changes in interest rates.
How Do TIPS Work?
Most traditional bonds offer a fixed periodic interest through their maturity at which point the owner – whether it’s an individual or mutual fund – are also 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 solve for that 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%. (You can find a fuller explanation of TIPS and TIPS mutual funds here.)
TIPS have been around 25 years, but the current bout of inflation is the worst since the early 1980s. At the same time, inflation has moved higher in an extremely short period of time, fueled by the unusual circumstances of pandemic-driven supply chain problems coming out of a recession. That’s making for an environment unlike any seen by TIPS investors to date.
During 2021, TIPS were the best-performing major sector in the U.S. bond market. The Morningstar U.S. TIPS index rose 5.7% last year while the broad Morningstar U.S. Core Bond index lost 1.6%.
Most of that rally in TIPS took place in the second half of 2021 as the recovery from the pandemic recession took hold and as the first hints of supply chain worries emerged. That led to a flood of investor money into TIPS and inflation-protected fund strategies more broadly.
The Fed Switches Gears
The turn in performance in early January for TIPS coincided with a shift by the Fed to take more aggressive action to raise interest rates, and pull back on the bond-buying purchases it had been making to pump money into the banking system during the recession. Since the start of the year, the U.S. TIPS index has lost 4.2%.
“I would put it on the shoulders of the reversal of policy from the Fed and other central banks,” says Steve Rodosky, a managing director and portfolio manager at PIMCO. “Expectations have moved from nothing or very little on the policy rate front in 2022 and 2023 to four-plus hikes for calendar 2022.”
One way to see the impact of changes in expectations around inflation and the Fed is to track the so-called breakeven rate. This rate--the difference between the 10-year nominal Treasury yield and the 10-year Treasury Inflation-Protected Securities yield--represents the market’s expectation of what inflation will be 10 years down the line.
Over the course of 2021, the 10-year breakeven rose from 2% to 2.7%, reflecting expectations for higher inflation. The 5-year breakeven registered 2% at the start of the year to a peak of 3.2% in mid-November. When the December and January inflation reports both came in hotter than expected, it showed that inflation is proving stickier than many economists predicted. On the surface that would have suggested continued upward pressure on inflation expectations.
But that hasn’t been the case. The 10-year breakeven has fallen back to 2.4% and the 5-year to 2.8%. While still up from where they were a year ago, those levels are heading back toward the Fed’s long-run inflation target of 2%.
These readings show that “aside from front-loaded expectations of high inflation, the world expects a very tame inflation environment after that,” says Rodosky, who is a manager on the $12 billion Pimco Real Return Fund (PRRIX).
For TIPS, those declining expectations for future inflation are translating into expectations for lower future inflation adjustments and, as a result, lower prices.
Headwinds From Rising Yields
Another headwind for some TIPS investors has been the rise in regular Treasury yields. The yield on the U.S. Treasury 2-year note jumped to nearly 1.4% from 0.7% at the start of the year, while the yield on the 10-year note hit 2% last week up from 1.5%. Both these changes are substantial moves in a short period of time. 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 prices.
For this reason, Jacobson says that when bond fund managers and traders want to protect against--or bet on--an imminent rise in inflation, they will use short maturity TIPs that are less affected by changes in interest rates. For example, the TIPS bond maturing in July 2022 has risen in value so far this year even as longer-term TIPS have sold off, Jacobson says.
Another component has been an increase in what are known as “real yields.” Broadly, a real yield is a bond yield minus the inflation rate. Since the onset of the pandemic, real yields on TIPS have been negative. That means once investors account for the effects of inflation on their returns, even with the inflation protection offered by TIPS, investors would be essentially losing money on their investment.
Put another way, after inflation, “the premium you paid for that bond is so high, that you’re not going to make up enough income between now and the time the bond matures to make up for it,” says Jacobson.
What Quantitative Tightening Means for TIPS
One reason that TIPS real yields have been negative is that the Fed has been buying huge amounts of U.S. Treasury bonds as part of its efforts to support the economy, an action known as quantitative easing, or QE.
“You had investors pouring into the asset class” seeking inflation protection, Rodosky says, “looking for the same bonds that the central bank was already buying.”
Recently, real yields have been rising. In addition to the changing expectations for inflation, the Fed’s stepping back from the market is removing a massive source of demand that had pushed yields down. Fed officials have begun discussing shrinking the amount of bonds it holds – the opposite of QE – a step known as quantitative tightening. “Since 2020, the marginal buyer of a lot of fixed income has been the Fed,” says Rodosky. That is leaving traditional market participants to set prices, and they are demanding higher yields.
What’s Next for TIPS?
The question for investors starts with the role TIPS play in a portfolio. If it’s simply part of a longer-term asset allocation, that as would be the case, dollar-cost averaging in over time means not having to worry about current valuations.
But for a more tactical approach, the question revolves around what TIPS are currently pricing in for future inflation compared to what an investor expects to happen. “You want to buy TIPS when the breakeven rate is lower than your inflation expectations,” says Jacobson.
Looking back to the breakeven rates, the TIPS market is priced for inflation to be 2.8% over the next five years.
Pimco’s Rodosky sees an opportunity for investors to take out insurance against the possibility that inflation will be even stickier than it has been. “The market is priced for a pretty swift reversal of CPI levels down to where we are ending 2022 and going into 2023 in a 2.5ish range,” he says.
These expectations are based on the idea that once supply chain issues are resolved, inflation trends will go right back to pre-pandemic dynamics where globalization led wages and costs low and fiscal austerity in major economies kept a lid on economic growth, Rodosky says. Another outcome could be that the pandemic has altered the globalization story and households have considerably more pent-up demand from the last two years than is being factored in. Rodosky says if that’s the case, “the cost of insurance is quite low right now.”
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