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by Ronald Zuvich and Hui Hui Huang Given the increase in the national deficit and the Federal Reserve’s quantitative easing policy amidst a sluggish economy and uncertain labor market, investor expectations have fluctuated between deflationary and inflationary concerns. For those with higher inflation expectations, Treasury Inflation Protected Securities (TIPS) may be an attractive vehicle to hedge these concerns. In this article, we seek to explain how TIPS may add value to a portfolio. To do so, we explore the mechanics behind TIPS, nominal and real interest rates, and the breakeven yield. We then examine how TIPS may help diversify a portfolio and the potential risks should inflation turn out to be lower than expected. Finally, we compare the inflationary hedge capability of TIPS versus other traditional inflation hedges such as commodities and real estate. Background on TIPS TIPS are government securities that provide investors with the opportunity to hedge inflation by indexing the principal amount purchased to the U.S. Consumer Price Index (CPI-U). First issued by the United States in 1997, TIPS currently comprise about 8% of outstanding U.S. marketable government issues. TIPS offer a return equal to the original real yield at issuance plus the rate of inflation, as measured by the CPI-U (urban non-seasonally adjusted consumer price index) lagged by two months, while having a deflation floor via a guaranteed payment of principal at maturity. As inflation increases, the final maturity value of the TIPS issue increases by an amount equal to the increase in the CPI index over the life of the bond. The CPI adjustment is “credited” semiannually at the same time as the regular coupon payments. Interest is earned and paid on this semi-annually changing balance such that absolute interest payments have the potential to increase over time. Thus, TIPS valuation is driven by two primary factors – movements in real interest rates and changes in the CPI. With regards to changes in real interest rates, TIPS behave no differently than any other fixed income instrument; TIPS prices exhibit an inverse relationship to real interest rates. However, in contrast to nominal bonds, TIPS are unique in that their final maturity value is completely hedged against future increases in inflation. Nominal vs. Real Interest Rates and Their Implications for TIPS Valuation Nominal yields broadly encompass three components - a real yield, an expected inflation component to compensate for changes in purchasing power, and an inflation risk premium to compensate for the uncertainty of actual inflation. Therefore, nominal bonds compensate investors not only for expected future inflation but also for the volatility of expected future inflation. The nominal yield curve is then equal to the real yield curve plus expected future inflation and the inflation risk premium. These two components represent the “difference” between the nominal and real yield curve. What does this mean for TIPS valuations? We know that changes in interest rates will dominate bond valuation – however, which of the three components of the nominal yield curve is driving the change in interest rates is crucial to TIPS valuations and their relative performance against nominal Treasuries. For example, if nominal rates were to increase due to an increase in expected inflation, nominal Treasuries would suffer while TIPS values should increase(the principal amount is adjusted upward by the increase in the CPI). If the increase in inflation is unexpected, TIPS will further appreciate from the upside inflation surprise as the principal amount (via future CPI adjustments) is expected to further increase over time. On the other hand, a decrease in nominal interest rates caused by a drop in expected inflation would lower investor demand for TIPS while nominal Treasuries would actually increase in value (simply because nominal rates would have declined). If real interest rates were to decline, nominal Treasuries and TIPS would both benefit. Conversely, we should note that TIPS have recently been issued with historically low real yields, a significant increase in which would be of concern to a TIPS investor. Consequently, TIPS will outperform nominal Treasuries if expected inflation increases and will underperform nominal Treasuries if expected inflation decreases. Given the significance of inflation expectations to TIPS valuation, it is important to gauge the current market consensus of inflation expectations to evaluate whether TIPS will perform well in the future. Breakeven Yield The yield on nominal Treasuries at issuance encompasses both inflation expectations and the real yield curve. TIPS offer a fixed but lower coupon than nominal Treasuries, and this difference in yields can largely be attributed to the expected inflation over the life of the securities. The difference between the yield of equivalent maturity TIPS and nominal Treasuries is the breakeven yield. When this difference is lower than the inflation expectation of a given investor, TIPS become attractive. However, should inflation actually turn out to be lower than the breakeven yield, TIPS will have underperformed nominal Treasuries. For example, a TIPS issue with a real yield of 0.5% at issuance when a comparable nominal Treasury is yielding 2.5% implies a combined annual expected inflation rate and inflation risk premium of 2%. In this case, the investor effectively pays to protect against a minimum of 2% inflation. If inflation turns out to be less than 2%, the investor will have overpaid for the TIPS security. Exhibit 1 — 10 Year Nominal and Real Yield Curves Exhibit 2 — Implied Annual Inflation Rate
Exhibit 3 — Short Maturity U.S. Treasuries vs. TIPS Exhibit 4 — Long Maturity U.S. Treasuries vs. TIPS
If held to maturity, TIPS act as a hedge against unexpected increases in inflation as measured by the CPI-U index. However, it is also important to examine how they have performed vs. other tangible asset classes traditionally viewed as inflation hedges, such as real estate and commodity indices. Since their inception in 1997, TIPS have outperformed both commodities (as measured by the DJ-AIG Commodity Index) and the monthly CPI index on a cumulative basis. While the NCREIF index has outperformed the TIPS index on a cumulative basis, its monthly returns are far more volatile (the “smoothing” effect of the NCREIF’s appraisal-based performance and valuation results in far lower reported volatility than would be expected from a risky, illiquid asset class). Furthermore, real estate valuations are not primarily inflation-driven but are determined more by region-specific economic growth and supply and demand and, more recently, credit underwriting standards and speculation. The monthly returns of commodities have been especially volatile and can be significantly influenced by trading effects such as central bank intervention in the gold market, fluctuations in the U.S. dollar, and investor speculation. Thus, it appears that TIPS are not only the second best performer among these four alternatives but also the most pure inflationary hedge if held to maturity (as discussed above, their values can be sharply affected by changes in real rates or inflation expectations, especially in the short to intermediate term). There is also far less risk in purchasing TIPS for the buy and hold investor due to the guarantee to receive at least the par amount purchased (via the deflation floor) at maturity, whereas commodities and real estate could result in a sharp loss of principal if purchased at market peaks (e.g., a 2006 real estate purchase). TIPS as a Portfolio Diversification Tool TIPS can also act as an effective portfolio diversification tool due to their historical low correlation with other assets and attractive risk-return profile. Given the attractive historical risk-return profile of TIPS since their inception in 1997, one would expect a portfolio optimization tool to maximize a plan’s allocation to TIPS. For illustrative purposes, we ran an optimization using J.P. Morgan’s Online Portfolio Analytics Lab (www.iac-opal.com) toolkit. We assumed the default allocation of a hypothetical defined benefit pension plan to be 10% TIPS, 30% Barclays Aggregate (nominal fixed income), 20% non-US equity (MSCI EAFE), and 40% domestic equity (S&P 500). The optimization used the entire historical returns series for the four asset classes, setting 20% as the maximum allocation to TIPS and 10% as the minimum allocation to both respective equity components. As shown in Exhibit 5, the default or “target” portfolio exhibits an expected return of 9.64%, standard deviation of 9.76%, and Sharpe Ratio of 0.75. When the optimization is run with the goal of maximizing the Sharpe Ratio, the allocation to TIPS is increased to the maximum allowable 20%, and the Sharpe Ratio increases from 0.75 to 0.88. While in this case the Sharpe Ratio also would have benefited from an increase to the Barclays Aggregate allocation, there is added benefit in further diversifying the fixed income portion of the portfolio (as the correlation between the Barclays TIPS and Aggregate indices is 0.74 using the entire TIPS return history). Exhibit 5
Source: J.P. Morgan’s Investment Analytics & Consulting Group, Barclays Capital, MSCI, Standard & Poors
Institutional investors have gradually increased their allocation to TIPS over time. Among our client base, we have noticed that public defined benefit pension plans have shown increased interest in TIPS in recent years, with several public plans allocating up to 8 - 10% of portfolio assets to TIPS. Corporate defined benefit pension plans appear to be less invested in TIPS, although many plans have a 2 - 5% allocation to the asset class. For plans and institutions that have high inflation expectations or want to hedge future inflation, we have shown that TIPS may prove to be an attractive investment . Since there are a limited number of TIPS issues outstanding, many plan sponors and institutional investors manage their TIPS portfolios in-house by purchasing specific TIPS issues in their fixed income portfolios. In the case of public defined benefit pension plans, we have noticed a trend toward the purchase of longer maturity TIPS issues due to the plans’ long-term investment horizons. Clearly, short term TIPS (1-5 years) can be more volatile because of the higher volatility of inflation and interest rates in the short term. In some cases, active managers may trade based on their specific inflation forecasts versus the market consensus as measured by the breakeven yield and the forward markets. Given this volatility, it is not surprising that there has been a marked increase in the number of active TIPS and global inflation-linked managers over the last several years. In our view, it is debatable whether TIPS should be included within the fixed income asset class or considered a separate inflation-linked asset class. As we have previously mentioned, TIPS behave very differently than typical fixed income instruments in certain scenarios. If interest rates increase, a pension plan’s liabilities and Long Duration fixed income assets should decrease in value. However, if the increase in rates is due to unexpected inflation, TIPS values will increase while the value of a plan’s liabilities and nominal bonds will fall. Conclusion As we have shown, since their inception in 1997, TIPS have performed well compared to other traditional inflation hedges. In our opinion, TIPS may offer an attractive risk-return profile from a portfolio diversification perspective. Furthermore, TIPS have added to market transparency by allowing investors to directly observe the real yield curve, and their valuation is directly affected by changes in real rates, expected inflation, and the volatility of expected future inflation. For long-term investors looking for an inflation hedge and those forecasting inflation to be higher than the market consensus as measured by the breakeven yield, TIPS are worth further consideration as a suitable asset class.
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