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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 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 real 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 real 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 adjusted for inflation
- Coupon rate fixed based on real interest rate
- Coupon payment adjusted for changes in inflation
The Bloomberg U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. The Bloomberg U.S. High Yield 2% Issuer Capped Index is an unmanaged index that covers U.S. corporate, fixed-rate, non-investment grade debt with at least one year to maturity and at least $150 million in par outstanding. Index weights for each issuer are capped at 2%. The Bloomberg U.S. Treasury Index includes public obligations of the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded. STRIPS are excluded from the index because their inclusion would result in double-counting. The Bloomberg U.S. Treasury Inflation Protected Securities (TIPS) Index includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade and have $250 million or more of outstanding face value. The Bloomberg U.S. Treasury TIPS 1-10 Year Index includes all publicly issued, U.S. Treasury inflation-protected securities maturities between 1 and 10 years, are rated investment grade and have $250 million or more of outstanding face value. The Citigroup World Government Bond Index is a market-capitalization-weighted index consisting of the government bond markets. Country eligibility is determined based on market capitalization and investability criteria. All issues have a remaining maturity of at least one year. The Consumer Price Index for All Urban Consumers (CPI-U) measures the changes in the price of a basket of goods and services purchased by urban consumers. The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization- weighted index of U.S. Equity REITs, including all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property. The MSCI EAFE Index is composed of all the publicly traded stocks in developed non-U.S. Markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. The S&P GSCI Index is an unmanaged world production-weighted index composed of the principal physical commodities that are the subject of active, liquid futures markets.
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.