Don’t Like TIPS

Now that inflation is increasing some, recommendations to own TIPS are proliferating.  I don’t agree for several reasons:

  1. TIPS yields are too low.  In an era of low yields, compounding interest income is the only way investors can build even a modicum of wealth.  Capturing incremental income becomes essential to achieving acceptable returns, and Treasuries do not offer enough income.  For example, since 1/1/2010, the Treasury and TIPS market have produced average annual returns of only 2.9% and 3.3%.  The investment grade corporate market has returned 5.5% per year and the high yield corporate market has returned 7.9% per year.  Even the muni market has returned a percentage point per year more than TIPS.  Compounding those better annual returns made a big difference to portfolio values over  the last eight years.
  2. TIPS perform poorly as market yields rise.  TIPS yields rise along with Treasury yields, albeit somewhat slower.  Thus far in 2018, total return for the TIPS market is -0.9%, only slightly better than -1.2% from nominal Treasuries.  Returns from corporates have been mostly positive.  If the rise in yields were to become severe, TIPS would very likely suffer steeply negative returns.  In 2013, the total return for the TIPS market index was -9%.  In the second half of 2016, it was -2.2%.  I have heard some say that if you expect a big jump in inflation, buy TIPS.  No, because in that event the Fed would tighten more aggressively, market yields would probably rise sharply and returns on all but the short-maturity TIPS would probably be very negative.
  3. Tips are not reliable indicators of future inflation or even of inflation expectations.  Over the past five years the inflation forecast implied by TIPS spreads has varied from as high as 2.6% in 2013 to 1.6% last June.  It is around 2% now.  That spread always increases when Treasury yields rise, as in 2013 and this year, because TIPS yields rise more slowly.  The spread always narrows (implied inflation rate gets smaller) when nominal yields are declining, as in the first half of last year.  Inflation expectations are usually thought to change slowly, not as often as the TIPS spreads would imply.
  4. There are better ways to hedge against a rise in inflation.  One example would be a short-duration portfolio of investment grade and/or high yield corporates.  The short durations would moderate price declines, and the continuous run-off of maturing issues allows for the purchase of higher yielding issues.  Thus, yields on these portfolios tend to rise as market rise.  The higher coupon income from the corporates would be expected to produce much better returns than a portfolio of short-duration TIPS.  That was true in 2013 and 2016 when the short duration corporates produced positive returns while most TIPS returns were negative.

To be sure, owning corporate bonds entails credit risk.  That risk escalates during recessions.  If, therefore, interest rates and market yields were to rise to levels that could induce a recession, it would be a good strategy to sell corporates and buy TIPS.  But in view of the most likely path of the economy in 2018, it is, in my view, still too early to be buying TIPS.

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