Is It Time for TIPS?

The outlook for inflation has been top of mind for markets recently with a series of economic data showing larger than expected increases in wages and inflation. As a result, some market participants are starting to take a harder look at Treasury Inflation-Protected Securities (TIPS). TIPS combat the erosion inflation can have on bond values via a semi-annual principal adjustment that’s based on changes in the Consumer Price Index (CPI). As with any financial market, prices are forward looking and will change based on investors’ expectations for inflation moving forward, though the principal adjustments that TIPS provide is ultimately based on actual CPI.

Over the past two years, TIPS have outperformed both Treasuries and the broader high-quality bond market, as shown in the chart below. A major driver of this strength was an increase in the market’s inflation expectations, which have expanded from 1.2% in February 2016 to 2.1% today (based on the difference between the 10-year Treasury yield and 10-year TIPS yield). Chief Investment Strategist John Lynch explains, “While TIPS have performed well over the past two years, with 10-year breakeven inflation expectations just above 2.1%, it may be tough for them to perform as well moving forward without a significant rise in the inflation outlook. It’s also important to note that if such a move were to happen, it could lead to a more aggressive Federal Reserve which may, counterintuitively, dampen inflation expectations and lead TIPS to underperform Treasuries.” We discuss the drivers of TIPS performance, and our outlook for the asset class in more detail in this week’s Bond Market Perspectives, which will be out later today.

IMPORTANT DISCLOSURES

The economic forecasts set forth in the presentation may not develop as predicted.

All performance referenced is historical and is no guarantee of future results.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

Treasury Inflation-Protected Securities (TIPS) help eliminate inflation risk to your portfolio, as the principal is adjusted semiannually for inflation based on the Consumer Price Index (CPI), while providing a real rate of return guaranteed by the U.S. government. However, a few things you need to be aware of are that the CPI might not accurately match the general inflation rate; therefore, the principal balance on TIPS may not keep pace with the actual rate of inflation. The real interest yields on TIPS may rise, especially if there is a sharp spike in interest rates. If so, the rate of return on TIPS could lag behind other types of inflation-protected securities, like floating rate notes and T-bills. TIPS do not pay the inflation-adjusted balance until maturity, and the accrued principal on TIPS could decline, if there is deflation.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS (agency and non-agency).

Bloomberg Barclays U.S. Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include T-bills (due to the maturity constraint), zero coupon bonds (strips), or Treasury Inflation-Protected Securities (TIPS).

Bloomberg Barclays U.S. Treasury Inflation Notes Index consists of Inflation-Protection securities issued by the U.S. Treasury.

This research material has been prepared by LPL Financial LLC.

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