🏛️ TIPS (Treasury Inflation-Protected Securities)

The US government issues Treasury Inflation-Protected Securities (TIPS) to provide protection against inflation. The principal value of TIPS increases as the Consumer Price Index (CPI) rises.

📌 Key points

• TIPS are Treasury Bonds designed to protect investors from inflation. 🔗 Learn about Treasury Bonds

• Deflation can reduce the par value of TIPS, but at maturity, investors will never receive less than the original par value.

• TIPS interest rates are lower than traditional non-TIPS bonds, as they adjust for expected inflation.

• In the US, TIPS earnings are taxable. If deflation lowers the par value, this loss can be used to offset other income gains.

• TIPS can be purchased directly through a brokerage account or via a mutual fund or exchange-traded fund (ETF) that invests in TIPS.

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Advantages and Disadvantages

First issued by the U.S. Treasury in 1997, TIPS are fixed-income securities that pay interest on the principal. The interest is adjusted for changes in the Consumer Price Index (CPI) and provides a small additional return.

✅ These are some good reasons to buy TIPS:

(1) Easy Protection Against Inflation -TIPS provide a simple way to protect investors from losing purchasing power due to rising inflation.

(2) Hedging Against Hyper-Inflation -If the economy is heading toward hyper-inflation, TIPS returns can significantly exceed those of regular government bonds.

(3) Supporting Income-Focused Portfolios -TIPS are a suitable component for income-focused portfolios, especially for risk-averse investors.

❌ When TIPS may not be a good idea:

(1) During Deflation -In a deflationary environment, TIPS may perform poorly. They track inflation, not interest rate levels.

(2) When Accurate Cash-Flow Predictions Are Needed -TIPS returns are uncertain, so investors cannot reliably predict future cash flows.

(3) If You Live Outside the US -TIPS are designed for US inflation, so they may not be suitable for investors not exposed to the US dollar.

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When Investors Should Buy TIPS

In short, here are the simple conditions for buying TIPS:

■ When to Buy: When you expect an inflationary environment, but not very high interest rates

■ When Not to Buy: When you expect deflation or anticipate interest rates rising faster than inflation

Doing the Math

To decide when to buy TIPS, investors should compare expected inflation rates with current bond yields. Here’s an example:

EXAMPLE:

Suppose annual inflation over the coming years is expected to be 2.5%, and the 10-year government bond yields 3.0%. This creates a 0.5% gap between expected inflation and bond yields:

■ If TIPS interest is 0.5% or higher, it is a good time to buy TIPS

■ If TIPS interest is significantly below 0.5%, it is not a good time to buy TIPS

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Using TIPS as an Interest Rate Forecasting Indicator

As mentioned, TIPS are inflation-protected securities. By comparing TIPS to US government bond yields, we can create useful metrics to forecast future interest rate levels.

(1) TIPS vs the 10-Year Bonds

In the chart below, TIPS (ETF: NASDAQ) is compared to 10-year US government bond yields. Historically, the two move in opposite directions. However, this pattern appears to change in early Autumn 2020. This divergence indicates the economy is entering a transitional phase and serves as an important signal.

Chart: TIPS compared to the U.S. 10-year bond yield

 

(2) TIPS/TLT Ratio vs the 10-Year Bonds

Here, we use the TIPS/TLT ratio.

TLT is the NASDAQ symbol for the iShares 20+ Year Treasury ETF, which invests about 95% in U.S. government bonds.

Since the par value of TIPS follows the Consumer Price Index (CPI), it reflects inflation. In contrast, the TLT ETF reflects long-term U.S. Treasury yields.

■ We use the ratio of AMEX TIPS to NASDAQ TLT ETF (upper chart)

Chart: TIPS/TLT Ratio compared to the U.S. 10-year bond yield

Source: TradingView (Symbol: AMEX:TIP/NASDAQ:TLT)

👉 Notes:

• Historically, the two charts (TIPS/TLT Ratio and U.S. 10-year bond yield) move in the same direction.
• However, currently, the U.S. 10-Year Bond yield is lagging behind the TIPS/TLT Ratio.

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Conclusions About Future Interest Rates

The first chart showed that starting in Autumn 2020, the bond market entered a transitional phase. The second chart indicates that the 10-Year Bond yield is lagging behind the TIPS/TLT Ratio, suggesting that 10-Year Bond yields are likely to rise. This could spell trouble for the FED.

 

SOURCES:

• TIPS:

https://www.nasdaq.com/glossary/t/treasury-inflation-protected-securities

https://allstarcharts.com/treasury-inflation-protected-securities-lead-interest-rates-lower/

• TLT:

https://www.ishares.com/us/products/239454/ishares-20-year-treasury-bond-etf

 

■ What are TIPS (Treasury Inflation-Protected Securities) and How to Use Them to Predict Interest Rates

Giorgos Protonotarios, Financial Analyst

for TradingCenter.org (c)

13th of May 2021