Are TIPS Riskier or Safer than Nominal Treasuries?

The version of inflation which drives TIPS principal values comes from the Consumer Price Index for Urban Consumers (CPI-U), available from this page at the Bureau of Labor Statistics. The principal adjustment due to CPI-U fluctuations is called the index ratio. The index ratio is a number like 1.01, which means that the principal of your TIPS investment is 1.01 times higher than the original principal balance at the time of issue. The index ratio can be located at the TreasuryDirect website.

While the index ratio can rise in periods of high inflation, it can also fall if there is deflation. For example, it can drop from 1.01 down to 1.005 when inflation runs at -0.50%. For an investor who owns $1,000 principal amount of a TIPS bond, when the Index Ratio is 1.01, the TIPS coupon rate will be paid on a principal of $1,010 (i.e., $1,000 x 1.01), but when the index ratio is 1.005, the coupon rate will apply to a principal amount of $1,005. A more detailed example of how TIPS index ratios effect principal and coupon payments is available here.

Though the principal payment may fall based on the index ratio associated with a particular TIPS bond, ultimately it cannot go lower than the original principal value of the bond (see quote above). Also, TIPS held in taxable accounts pay Federal taxes on the coupons received every year, as well as on principal growth in each year. You should consult with a tax professional about the exact tax treatment of TIPS, but some information is available from the TreasuryDirect website.

TIPS and inflation protection

Because TIPS principal is adjusted by the rate of inflation, TIPS investments have no inflation risk, unlike regular Treasury bonds. When inflation rises, regular Treasuries continue to pay the same nominal dollar amounts, but such unchanged nominal payments are now worth less in real terms (i.e., in terms of the goods and services that can be bought with the fixed nominal payments).

On the other hand, when inflation rises, the principal amount of TIPS gets adjusted upward, and the investor is owed back more money from the U.S. government when the TIPS mature. In addition, the coupon rate is paid on the higher principal amount.

In this way, TIPS investors do not face inflation risk, since the real purchasing power of their TIPS investment stays constant (under the assumption that the CPI-U is a good price proxy for individual investors).

Because TIPS adjust their principal upwards in times of high inflation, the coupon rate paid by TIPS bonds (or, more accurately, their yield) is lower than the coupon rate (yield) paid by nominal Treasury bonds. The above figure shows the evolution of regular Treasury yields (in red) and TIPS yields (in blue) since 2000. TIPS yields are almost always lower than nominal yields, because the extra inflation compensation priced into nominal yields is explicitly captured by the principal adjustment of the TIPS bonds.

The difference between nominal and TIPS yields is called the breakeven spread, shown for 10-year Treasuries and TIPS in the above figure. The breakeven spread reflects market participants’ expectation of future inflation. The higher the breakeven spread, the higher the market’s belief about the future rate of inflation. The lower the spread, the lower the market’s belief.

In addition to containing a market forecast of the future inflation rate – which determines the anticipated increases in TIPS principal amounts due to future index ratio adjustments – the breakeven spread contains a risk premium, which compensates investors for holding Treasuries versus TIPS.

TIPS risk premia: positive or negative?

Should the TIPS risk premium be positive (i.e., breakeven spread is above the anticipated level of inflation) or negative (i.e., breakeven spread is below the anticipated level of inflation)? That depends on whether holding Treasuries or TIPS is more risky.

If it’s riskier for investors to hold regular Treasuries – for example, because this exposes investors to inflation risk – then the breakeven spread should be larger than the anticipated rate of inflation, which reflects the extra risk compensation received by investors for holding nominal, non-inflation-protected Treasuries.

However, in slowing economic times, the index ratio applied to TIPS principal amounts can adjust downwards, if the economy enters deflation (according to the TreasuryDirect website: “The principal of your TIPS goes up and down with inflation and deflation.”). When the economy slows, interest rates typically fall, and the prices of regular (nominal) Treasury bonds rise because, even in the presence of deflation, nominal Treasury bonds always pay the same fixed coupon and principal amount. However, in slowing economic times, TIPS principal can fall due to drops in the index ratio, meaning that the dollar coupon paid by TIPS bonds can be lower in bad times, and TIPS that come due in bad times may pay back lower principal amounts (though not lower than the original principal of the TIPS bonds).

It might thus be riskier to own TIPS during market sell-offs, because their poor performance during times of economic stress may outweigh the benefits they provide to investors in terms of inflation hedging.

A rough estimate of the sign of the breakeven spread risk premium can be obtained from looking at realized returns of investments in ordinary Treasuries and in TIPS over the years. As the next chart shows, medium-duration TIPS have outperformed medium-duration nominal Treasuries by around 0.85% per year over the last 25+ years. Since TIPS have outperformed regular Treasuries, it suggests that the yield of TIPS was higher relative to Treasury yields than it should have been for the two asset classes to move exactly in line. This is another way of saying that breakeven spreads were too low relative to the level of realized future inflation.

This comparison isn’t perfect, because the maturity composition of the two indexes are not exactly the same, and longer-dated bonds typically command a higher yield than short-dated ones. Therefore, part of the story might be that the TIPS bonds outperform because they are slightly longer-dated than the medium-duration Treasury benchmark. However, the TIPS outperformance visible in the above chart does suggest that the realized inflation rate was higher than the breakeven inflation rate. That is, the risk premium in breakeven spreads appears to have been negative since the late 1990s.

Of course, the sign or the risk premium in the breakeven spread may change over time if investor concerns shift from slower economic growth to inflation fears. But, at least over the last several decades, breakeven spreads seem to have slightly underestimated the realized rate of future inflation.

How macro-sensitive are TIPS?

If TIPS have historically outperformed regular Treasuries, it might be because holding TIPS involves certain risks for which investors demand compensation in the form of higher returns. One way to see the cyclical risks from owning TIPS is to look at the behavior of TIPS breakevens during recessions (shown as the grey, shaded area in Fig. 3).

When breakevens collapse close to zero, this means that TIPS yields get very close to Treasury yield, indicating times of TIPS underperformance. As the figure makes clear, TIPS have underperformed during the last two recessions, when markets priced in very low anticipated inflation levels. Thus, regular Treasuries offer a better hedge for bad macro environments, which are typically times of falling nominal Treasury yields and rising nominal Treasury prices (see earlier figure).

The next table analyzes the performance differential between TIPS and regular Treasuries in different market environments. The column labeled “vix” shows the average level of the VIX volatility index across all months in the sample bucketed by the level of the VIX index. Bucket 1 refers to the 20 percent of all months with the lowest VIX levels. Bucket 2 refers to the next 20 percent of all months, all the way to Bucket 5, which refers to the 20 percent of months with the highest VIX level. The column labeled “V:vix” shows the average value of the TIPS return minus the regular Treasury return in each set of months.

TIPS outperform Treasuries by an average of 33.6 basis points in months falling into the middle 20 percent bucket based on VIX levels (Bucket 3). In high VIX months (Bucket 5), TIPS underperform regular Treasuries by 10.8 basis points, on average. In the other three VIX-based buckets, TIPS tend to slightly outperform regular Treasuries. Since bad macro months (e.g., those during recessions) tend to be associated with a higher VIX (and thus likely fall into the fifth VIX bucket), this is consistent with the cyclical pattern of poor TIPS performance during bad times seen in breakeven spreads.

The column labeled “cpi” shows the average year-over-year CPI inflation in months bucketed by their year-over-year CPI inflation. Again, Bucket 1 contains the 20 percent of all months with the lowest year-over-year levels of CPI inflation, while Bucket 5 contains months with the highest year-over-year percent changes in the CPI index. TIPS tend to outperform Treasuries in months with low past 12-month inflation growth (Buckets 1, 2, and 3) but TIPS underperform Treasuries in months where that last-12-month inflation was high (Buckets 4 and 5). In this case, TIPS underperform regular Treasuries, respectively, by 13.9 and 12.5 basis points per month on average.

This may be surprising because TIPS are supposed to protect against inflation. It turns out that the majority of this protection takes place prior to the onset of inflationary episodes.

The column labeled “cpi+12” groups months based on the level of year-over-year CPI inflation that will ensue over the future 12-month period. In the months prior to 12-month period of low inflation (Buckets 1, 2, and 3), TIPS tend to underperform regular Treasuries by between 7.1 to 17.8 basis points per month, on average. However, in months that precede high-inflation 12-month periods, TIPS do very well, outperforming regular Treasuries by between 34-48 basis points per month, on average. Thus TIPS do provide an effective inflation hedge, and do so in an anticipatory way in the year prior to the onset of inflation.

Finally, the column labeled “gt2” splits months into five buckets based on the level of nominal two-year Treasury yields. TIPS outperform regular Treasuries by between 12 and 24.8 basis points per month, on average, in months with low levels of two-year rates. When interest rates are high, e.g., in Bucket 5 when the average two-year rate is 5.5 percent, TIPS underperform regular Treasuries by 12.2 basis points per month, on average. The mechanism may be that low interest-rate periods are associated with high future inflation, which is anticipated by TIPS, which thus rally in low interest-rate months. Similarly, high interest rate periods may be followed by periods of low inflation, and thus weaker TIPS returns.

The right role for TIPS

The next table shows the correlation of the monthly returns of four different bond types with the returns of a broad selection of other asset classes. The left-most column shows the correlation of the monthly returns of nominal medium-duration Treasuries (USTREAS) with the returns of other asset classes.

Nominal treasury returns are negatively correlated with returns for S&P 500 stocks (SPX), Nasdaq stocks, Russell 2000 (R2000) stocks, commodities, and high yield bonds (USHY). On the other hand, nominal Treasuries are positively correlated with investment grade bonds (USIG), gold, and TIPS (USTIPS).

However, the next column shows that TIPS are positively correlated with stock, commodity, and high yield bond returns. At the same time, TIPS are also positively correlated with the returns on investment grade bonds, gold, and nominal Treasuries. In fact, of the four bond asset classes I investigate, TIPS have the highest correlation with gold, consistent with the inflation-hedging role played by both asset classes.

The third column of the table shows that investment grade bonds have a correlation structure with the other asset classes that looks much more like that of TIPS than that of nominal Treasuries. High yield bonds, the right-most column, exhibit the most equity-like behavior of the four asset classes, as may have been expected. Based on this correlation structure, I conclude that TIPS behave more like investment grade bonds than they do like nominal Treasuries.

While TIPS have no default risk – or more accurately, as little default risk as U.S. nominal Treasury bonds – they are not risk-free in nominal terms, because their index ratios can adjust down in times of deflation (though the principal paid back by TIPS can never fall below the original bond principal amount). Because of this principal adjustment, TIPS prices exhibit more pro-cyclical variation than do nominal Treasuries, whose prices typically exhibit counter-cyclical behavior (i.e., higher in bad times and lower in good times). TIPS do hedge against inflation, but the net effect of their added cyclicality and inflation-fighting benefits is that investors demand risk compensation for holding TIPS. Evidence for this comes in the form of TIPS outperformance relative to nominal Treasuries since the start of my data in 1997. This suggests that breakeven spreads are too low relative to actuarially fair estimates of future inflation.

A detailed analysis of the role of TIPS in investor portfolios will be a topic for another day, but TIPS should not fully displace nominal Treasuries in investor portfolios. Instead, TIPS can serve to replace a combination of nominal Treasuries and investment grade corporate bonds. This will leave the cyclical risk profile of the portfolio roughly unchanged, while providing an effective inflation hedge. Indeed, should inflation concerns rise from current levels, the breakeven spread risk premium can turn positive from its (apparently) negative current level, which would be associated with outperformance of TIPS relative to nominal Treasuries. On the other hand, nominal Treasuries will likely outperform TIPS should the economy slow down or enter a recession.

If you would like to discuss the role that TIPS can play in your own investment portfolio, please reach out at [email protected].

Harry Mamaysky is a professor at Columbia Business School and a partner at QuantStreet Capital.

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