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Fixed income perspective: Treasury Inflation Protected Securities
Treasury Inflation Protected Securities (TIPS) are an often misunderstood fixed income asset class. Some investors hear “inflation” and assume that TIPS returns are perfectly correlated to changes in inflation. That is not the case. Investors should examine the subtleties and complexities of TIPS before seeking to take advantage of their long-term diversification benefits. Relative to TIPS overall, those that have a shorter duration (1-10 years) can offer a stronger correlation to inflation while offering similar return potential and lower volatility.
Understanding interest rates, inflation and TIPS
Investors sometimes forget that TIPS are bonds and therefore are subject to interest-rate risk. They also may not understand that inflation itself will not propel TIPS returns. Only inflation that is higher than the rate already expected by the market creates extra return. Other market factors may also influence the returns.
TIPS are an asset class driven by subtleties. They’re much more complicated than many investors think because their returns are driven by two factors: changes in interest rates and changes in inflation expectations. In addition, interest rates and inflation have to be two of the most difficult variables to accurately forecast.
To better understand the impact of rising rates on TIPS, let’s take a look at how TIPS work as individual bonds and within a mutual fund structure, and the performance factors that affect their total return. The performance of TIPS during periods of rising rates depends on the interplay of rising interest rates — which hurt their prices — and unexpected inflation, which help. Therefore, the actual performance of TIPS will vary depending on how the rate cycle and inflation environment play out. Still, TIPS can be a valuable portfolio diversifier for long-term investors given that the primary drivers of return are likely to be different than most exposures already in a portfolio.
How TIPS work
Treasury Inflation Protected Securities were introduced in the United States in 1997. The basic principle behind their construction is to index the principal and income on a U.S. Treasury for inflation. The structure of the bond is different from a regular U.S. Treasury in three main ways:
- Principal of bond is adjusted for inflation
- Coupon rate fixed based on “real interest rate” (in the event that real rates are negative, a minimum coupon of 0.125% will be used)
- Interest payment includes an inflation adjustment
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. It is not possible to invest directly in an index.
A word on risk
This information represents the opinion of Nuveen and is not intended to be a forecast of future events and this is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific securities or investment products. All investments carry a certain degree of risk, including possible loss principal and there is no assurance that an investment will provide positive performance over any period of time. Diversification does not insure against market loss. An investment in taxable fixed income securities is subject to certain risks, including interest-rate risk, income risk, and market risk. Interest payments on inflation protected debt securities will vary with the rate of inflation, as measured by a specified index. There can be no assurance that the CPI-U (used as the inflation measure by U.S. Treasury inflation protected securities) will accurately measure the real rate of inflation in the prices of goods and services. If the market perceives that the adjustment mechanism of an inflation protected security does not accurately adjust for inflation, the value of the security could be adversely affected. There may be a lag between the time a security is adjusted for inflation and the time interest is paid on that security. This may have an adverse effect on the trading price of the security, particularly during periods of significant, rapid changes in inflation. In addition, to the extent that inflation has increased during the period of time between the inflation adjustment and the interest payment, the interest payment will not be protected from the inflation increase.
Nuveen, LLC provides investment advisory services through its investment specialists.