Treasury inflation-protected securities (TIPS) vs. traditional sovereign bonds
In this survey we shall try to identify the main differences between traditional sovereign bonds and Treasury inflation-protected securities (or TIPS), and to do so we shall focus on the US market, although the conclusions may be extrapolated to other key markets such as Germany, the UK, etc.
The major conclusions are as follows, depending on whether or not they are held to maturity:
Buy the security and hold to maturity:
- Buying Treasury inflation-protected bonds guarantees a certain yield in real terms (once inflation has been discounted) over a particular period, provided they are held to maturity. They are therefore a good alternative for protecting one’s wealth against increases in inflation.
- To assess their attractiveness against that of a traditional bond, we have to take the fixed carry they offer plus an estimate of the average annual inflation we think there will be until the bonds mature. If the outcome is equal to or higher than what a conventional bond is offering, investment in TIPS will be interesting and vice versa.
For an investor sensitive to swings in bond prices:
- Contrary to when buying TIPS and holding to maturity, investors do NOT guarantee their capital conservation against increases in inflation if they sell them early or if they invest in this asset through an ETF or an investment fund. Indeed, investors may even be penalised by an increase in inflation because TIPS prices depend on the trend in real rates (which almost always move in the same direction as nominal rates, although with a lower volatility).
- Hence, if inflation rises, the most typical situation is that nominal and real rates also rise, negatively affecting the prices both of conventional sovereign bonds and inflation-protected bonds (although the falls in the latter are usually lower because the increase in inflation cushions the impact nominal rate increases have on their price).
1. How inflation-protected securities work and differences compared with conventional bonds
Firstly, we should underline that TIPS have the same backing and security as conventional sovereign bonds in terms of credit risk, therefore the likelihood of default is practically inexistent in the case of the USA. The main difference between the two is that TIPS are designed to protect investors against the effect of inflation over a particular term, irrespective of how this evolves. At present, TIPS only exist as long-term issues with 5-, 10- and 30-year maturities.
Inflation-protected bonds pay a fixed, half-yearly carry, which is set at the time of issue. Furthermore, the principal of the security is adjusted for inflation (benchmarked to the Consumer Price Index), therefore at maturity, the yield will be the same as inflation for the period, plus the fixed carry, which is therefore what dictates the investment yield in real terms. Investors know exactly what they are going to earn at maturity in real terms (i.e., once inflation has been discounted) unlike with a conventional bond where they know what they are going to earn at maturity but only nominally.
Below, we shall see an example of an investor who is undecided whether to buy a primary market issue of $1,000 of a conventional 10-year bond or to buy an inflation-protected security for the same term. At this time, the yield offered by the former stands at 4.5% whilst the TIP security is offering a fixed carry of 2%.
The investor, moreover, considers that inflation will remain stable at 2.5% p.a. for the next 10 years and, if they are right, the following table would be the yield on their investment in the two assets (measured in absolute and in real terms, taking inflation into account).
Therefore, in this case, the investment in inflation-protected securities would be more attractive. However, if annual inflation for the period were 1.5% instead of 2.5%, the conventional bond would return a better yield, as we shall go on to show.
Firstly, it is important to underline that the yield from both assets is certain, is published beforehand and coincides with the fixed carry they deliver, although for traditional bonds we know the annual yield they will produce in nominal or absolute terms (4.5%, in the example) and for inflation-protected securities we know the real yield they will accrue for the period (which coincides with the fixed carry rate, 2%, in the example), irrespective of how inflation evolves, as we can see in the summary table for the two scenarios assessed. There is only one exception: If there is a period of deflation, the real yield p.a. for an inflation-protected security will be the fixed carry plus the average annual rate of deflation, because the principal of such securities at maturity is always the same or higher than at the beginning.
In the first case, the yield being delivered by inflation-protected securities over the entire period (2% fixed carry +2.5% corresponding to inflation) is the same as that produced by the traditional bond (4.5%); however, the yield from the former is higher because, as we can see from the tables, the principal is adjusted for inflation and the carry yields are in turn calculated on the adjusted principal (which is increasingly higher, thus protecting not only the principal from the effect of inflation but also the carry, thereby providing a yield that is constant and stable in real terms) unlike the traditional bond, where both the principal and the carry yields remain constant. Hence, if the yield being delivered over the whole of the period is the same (in percentage terms), it is more attractive to invest in TIPS, providing that inflation is positive. If inflation lies at 0% or there is deflation, the yield of the two instruments will be the same (equal to their fixed carries), because as we commented earlier, the principal of the bond or security at maturity is only adjusted upwards (it is always the same as or higher than the original amount).
On the other hand, as is shown in table 2, if inflation is lower than the investor is expecting (in this example 1.5% instead of 2.5%), it would be more attractive to invest in conventional bonds, because the adjustments for inflation to the TIPS principal and carry do not offset their lower yearly yield.
In short, when it comes to deciding how attractive a conventional bond is at maturity compared to a TIPS, we must take into account the fixed carry they deliver and add to the latter the annual inflation we are expecting for the period. If the result of this calculation is that the TIPS delivers an equal or higher rate, this instrument is more attractive and if it is lower, the traditional bond would be the preferred option. It is obvious, therefore, that the difficulty and risk, when it comes to assessing such an investment in real terms, resides in correctly estimating future inflation.
It is also important to decide whether what we want is to have the certainty of obtaining a yield in nominal terms (buy traditional bonds) or if we prefer to guarantee a yield in real terms, for which a TIPS to maturity is the ideal solution, given that it is the only asset that over a particular term protects us in all certainty against inflation, thus guaranteeing a specific real yield.
2) Analysis for an investor sensitive to swings in bond prices
The foregoing analysis focussed on an investor who was buying a bond at issue and holding it to maturity. For those investors who are sensitive to price movements because they want to sell their investment prior to the maturity date or because they are positioned in an investment fund or ETF invested in this asset, we shall briefly try to analyse the factors which may affect inflation-protected security prices and their differences compared to a traditional bond.
Below we have a graph showing the price trend of an inflation-protected securities ETF against movements in the real interest rate of the 10-year sovereign bond (10-year sovereign bond yield minus the inflation forecast for that term), drawn on an inverted scale.
As we can see, the ETF price (which can be extrapolated to any bond that is traded on the secondary market or to an investment fund), moves in keeping with variations in the real interest rate, unlike traditional bond prices which move according to nominal rate variations. When the real interest rate falls, inflation-protected bond prices go up, and vice versa.
As the graph shows, nominal rates behave very similarly to real rates in the long term: When the nominal rate falls so does the real rate and vice versa, except when deflation is discounted like in 2008, a situation in which the real rate always rises, whilst nominal rates tend to fall. Therefore, the direction of bond and TIPS prices will be very similar in the long term: They will fall when rates rise and vice versa, except when a deflationary scenario is being discounted in which TIPS prices will fall and traditional bond prices will rise.
We should also point out that despite the fact that real and nominal rates move in the same direction, the scale of their respective movements is different, because normally nominal rate rises and falls are more pronounced, which results in more tempered variations in real rates due to the positive correlation that normally prevails between their two components (nominal rate – forecast inflation); when rates go up it is normally because there is a rise in forecast inflation. Hence, if we are expecting an environment of rate rises, although the price of the two assets will fall, it is usually preferable to invest in TIPS; however, to benefit more from a rates decrease, traditional bonds are usually a better option from the point of view of price variation, but it is also necessary to take the carry from the two instruments into account.
Furthermore, it is important to underline that unlike when buying and holding an inflation-protected security to maturity, investors do not guarantee their capital is protected against inflation increases if they are going to sell them early or if they are investing in an ETF or a fund; it could be completely the opposite, because they are sensitive to movements in TIPS prices, which will normally fall in periods of rate rises, in periods of rising inflation.