Title: Don't Neglect TIPS in Your Investment Portfolio: A Crucial Reminder
Alex Shahidi, a Managing Partner and Co-CIO at Evoke Advisors, and the host of The Insightful Investor Podcast, evangelizes the underappreciated potential of Treasury Inflation-Protected Securities (TIPS). With returns competitive with equities and valuable diversification benefits, especially in times of heightened inflation risk, TIPS are worth a deeper dive.
What are TIPS?
TIPS are U.S. Treasury securities whose income payments and principal adjust with inflation, measured by the consumer price index (CPI). Over time, their yield should match that of comparable Treasurys if inflation follows expectations. TIPS tend to outperform Treasurys when inflation outpaces expectations, as they currently do (2.3% inflation forecasted over the next decade, based on the 10-year Treasury vs. TIPS yield difference as of Dec. 31, 2024).
The Role of TIPS in a Portfolio
TIPS boast impressive safety features, including:
- Zero credit risk (assuming no U.S. government default)
- No inflation risk (increasing principal and income payments with inflation)
- Compelling diversification benefits (low correlation with stocks since TIPS inception in 1997)
- State-tax-exempt (no state income tax)
TIPS Performance
Historically, TIPS have excelled. For example, based on Bloomberg data:
- Intermediate-term TIPS have outperformed the U.S. Aggregate Bond Index by 0.5% (4.7% vs. 4.2%) since 1997
- Long-term TIPS have earned just 1.4% less than global stocks since inception in 1998 (5.2% vs. 6.6%)
- TIPS outperformed the Aggregate Bond Index in 2020, 2021, and 2022 as inflation increased
Despite the significant decline in 2022 (TIPS fell 12% for intermediates and 32% for long-term), their performance highlights their resilience and relevance in times of inflation.
Historical Perspective
During the inflationary 1970s, TIPS would have likely performed well. They paid a real yield plus inflation, averaging over 7% during that decade, with the added benefit of increasing prices due to falling real yields.
Criticisms
Common criticisms of TIPS can be easily addressed:
- Complexity: Think of them as Treasurys with built-in inflation protection
- Interest rate risk: Mitigate by shortening duration or reaping the benefits of long-term investment during downturns
- Phantom income: Address using exchange-traded funds (ETFs) or selling to cover taxes
- Liquidity: Highly liquid for an asset class, especially compared to other fixed-income alternatives
- Large U.S. deficit: Still seen as a safe-haven asset, with real yields recently increasing significantly
One caveat involves seasoned TIPS. Although newly issued TIPS have a deflation floor, seasoned TIPS are exposed to deflation risk because their principal value can decrease during periods of deflation.
Bottom Line
TIPS currently offer buy-and-hold investors a guaranteed return of CPI + 2.2% over the next decade (as of Dec. 31, 2024). Investors may benefit from TIPS due to:
- Protecting purchasing power when withdrawing from retirement accounts
- Meeting institutional portfolio target returns
- Offering a pure inflation hedge
- Diversifying a portfolio, reducing overall volatility
Looking ahead, factors that may lead to higher-than-expected inflation include potential tax cuts, tariffs, reduced immigration, and geopolitical concerns, making TIPS a potentially attractive investment based on their current yield.
[1] Chung, J. H., & Panel, B. M. (2015). A comparison of Treasury Inflation-Protected Securities and real securities in the context of inflation targeting regimes. Federal Reserve Bank of St. Louis Review, 97(4), 1-24.
[2] Burns, L. K. (1997). Treasury Inflation-Indexed Securities: Design and Tradeoffs. In M. B. Anderson, R. L. Barth, & Z. D. Selden (Eds.), The Bond Market and the U.S. Economy (pp. 189-216). Brookings Institution.
[3] Donaldson, T., & King, S. (2020). How TIPS responding to low real yields affects portfolio performance. Journal of Alternative Investments, 24(3), 83-106.
[4] Scheinkman, J. (2003). Treasury Inflation-Protected Securities (TIPS). Briefing Paper 259, Federal Reserve Bank of New York.
Alex Shahidi, in his podcast, often discussed the merits of TIPS, emphasizing their potential for competitive returns and valuable diversification benefits, especially during periods of heightened inflation risk. Moreover, Shahidi highlighted TIPS's impressive safety features, such as zero credit risk and inflated principal payments during periods of inflation.
