TIPS "treasury inflation protected securities" currently provide very little upside (return), but that exact statement can be made about just about any area of the fixed income market. Where they do present a potential opportunity is in relative terms against traditional Treasury bonds. Regardless, this post is less about the opportunity within TIPS and more about the return profile they provide. For a deeper dive into how TIPS function, I recommend this Vanguard piece.
What are TIPS?
TIPS provide an investor with real (i.e. after inflation) returns guaranteed by the U.S. government. You buy TIPS at a real rate, which is lower than traditional Treasuries by a 'break-even' inflation rate determined by the marketplace. For example, in the below post I will assume the nominal rate on a Treasury bond of 2.5% and a break-even inflation rate of 2.0%, resulting in a TIPS real yield of 0.50% (all relatively close to current levels for bonds with a 10 year maturity).
Return Profile of Treasuries vs. TIPS
The below chart is without a doubt an oversimplification, but the most important aspect is that nominal bonds (i.e. Treasuries) provide a nominal return (over a time frame equal to their duration) that is extraordinarily close to their yield to maturity. For this exercise we will ignore the path of returns (i.e. how they got there... which is important), so that we can focus solely on the relationship between inflation and returns (nominal and real).
Treasury Bonds
At the current yield of 2.5% and an 8-year duration, a 10-year maturity Treasury bond WILL provide an investor a nominal return very close to 2.5% over the next 8 years regardless of inflation. As Treasuries do not adjust for inflation, assuming an inflation rate at a constant level over the life of the Treasury bond, the real return of a Treasury bond is simply the nominal rate less the inflation rate. For example, if inflation is 3% and the Treasury bonds only return 2.5%, then real returns are negative -0.5%. On the other hand, if there is deflation, then the real return moves higher. For example, if deflation is -1% and the nominal yield is 2.5%, then the real return is 3.5%.
TIPS
Inflationary Environment
At a real yield of 0.5%, TIPS provide an investor with a real return equal to 0.5% if there is inflation, while the nominal return will increase by the rate of inflation. For example, if the inflation rate is a constant 2%, then TIPS provide the same nominal return as Treasuries (the fact they are the same, means the break-even is 2%). If inflation is above 2%, then TIPS provide a greater nominal return than Treasuries... if less, they provide a smaller nominal return than Treasuries.
Deflationary Environment
A TIPS investor is guaranteed to receive PAR at maturity, thus is given an embedded "deflation floor" option. As outlined in this Vanguard piece:
TIPS also provide some deflation protection to the principal (but not to the coupon payments). At maturity, if consumer prices have fallen so much that the inflation-adjusted principal would be below par, the Treasury will repay the principal at par value. In this manner, TIPS provide a “deflation floor.”
As a result, while nominal bond real returns move in a linear fashion to changes in inflation rates, TIPS cannot move negative (unless the real yield at purchase was negative) in nominal terms, thus the real return also increases in a deflationary environment (a ~0% nominal return when deflation is 3% = to a 3% real return).
Conclusion
In normal market environments when inflation is relatively stable, long-term returns tend to be similar for both Treasuries and TIPS. However, TIPS materially outperform in an inflationary environment, while Treasury outperformance is capped by a rate roughly equal to the break-even inflation rate in a deflationary environment. Thus, assuming a view that an inflationary and deflationary scenario are equally likely, the unlimited potential outperformance of TIPS vs. Treasuries in an inflationary environment and limited upside of Treasuries vs. TIPS in a deflation environment would sway an investor towards TIPS.
