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

TIPS (Treasury Inflation-Protected Securities)

First issued by the U.S. Treasury in 1997, TIPS are fixed income securities that (as bonds) receive interest payments on the face value. The interest payment is adjusted to cover Consumer Price Index (CPI), plus to offer a minor extra return.

Key points

-TIPS are Treasury Bonds that aim to protect investors from inflation.

-Deflation will reduce the par value of TIPS. However, upon maturity, investors never receive less than the original par value of the TIPS

-TIPS interest rates are smaller than traditional non-TIPS bonds (as they adjust for future inflation)

-In the US, TIPS earnings are subject to taxes. If deflation occurs, and the par value of TIPS is reduced, this may be used to offset other income gains

-You can directly buy a TIPS via a brokerage account or buy a mutual fund or an exchange-traded fund (ETF) that is invested in TIPS

 

Advantages and Disadvantages

These are some good reasons to buy TIPS:

(1) Easy Protection Against Inflation

TIPS can easily protect investors against the loss of purchasing power due to increasing inflation.

(2) Hedging Against Hyper-Inflation

If you predict the economy is entering into a hyper-inflation environment, TIPS return will considerably exceed the return of common government bonds.

(3) Serving Income-Focused Portfolios

TIPS are a nice component for income-focused portfolios such as portfolios of risk-averse investors.

When TIPS is not a so good idea:

(1) When the economy enters deflation

When the economy enters deflation, TIPS will prove a poor investment. Note that TIPS keeps up with inflation, and not with the level of interest rates.

(2) When you need to predict your future cash-flows with accuracy

Actually, TIPS returns are uncertain and unpredictable. This means investors can’t estimate their future cash flows from TIPS with accuracy.

(3) When you live outside the US

As TIPS is designed to deal with US inflation, if you are not exposed to the US dollar, it makes no sense to invest in TIPS.

 

When Investors Need to Buy TIPS

In a few words, these are the simple conditions for buying TIPS:

■ When to Buy: When you predict an inflationary environment, but not as high interest rates

■ When not to Buy: When you predict a deflationary environment, or you predict higher interest rates than the upcoming inflation

Doing the Math

In order to decide when to buy TIPS, investors should compare the expected inflation rates to the current bond yields. Let’s see an example.

EXAMPLE:

Let's suppose, the annual inflation for the upcoming years is expected at 2.5%, and the 10-year government bond is yielding at 3.0%. That means there is a 0.5% differential between the expected inflation and bond yields:

■ If TIPS interest is at 0.5% or higher, then it is a good idea to buy TIPS

■ If TIPS interest is significantly lower than 0.5%, then it is NOT a good idea to buy TIPS

 

 

Using TIPS as an Interest Rate Forecasting Indicator

As mentioned above TIPS is Inflation-protected security. Therefore, if we compare TIPS to US government bond yields, we can create smart metrics to forecast the future level of interest rates.

 

(1) TIPS vs the 10-Year Bonds

In the following chart, TIPS (ETF:NASDAQ) is compared to the 10-yer US government bond yields. As we can see, historically, the two charts move in an identical opposite direction. However, this seems to change in early Autumn 2020. This divergence between the two charts signifies that the economy has entered a transitional stage, and it is an important clue.

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

 

 

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

This time we use the ratio TIPS/TLT.

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

As the par value of TIPS follows the Consumer Price Index (CPI), it provides an insight into inflation. On the other hand, the TLT ETF provides an insight into the long-term US treasuries yields.

■ We are going to use a ratio incorporating the AMEX TIPS vs the 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)

Historically, the two charts (TIPS/TLT Ratio & U.S. 10-year bond yield) move in the same direction.

However, at this moment, the US 10-Year Bond yield is lagging behind the TIPS/TLT Ratio.

 

Conclusions About Future Interest Rates

The first chart showed that starting in Autumn 2020, the bond market entered a transitional stage. According to the second chart, the 10-Year Bond yield is lagging behind the TIPS/TLT Ratio. Most probably, the yields of 10-Year Bonds are going up. It smells like 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 for Predicting Interest Rates

Giorgos Protonotarios, Financial Analyst

for TradingCenter.org (c)

13th of May 2021