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TIPS, Inflation, and Your Portfolio

TIPS are an important tool for protecting your portfolio from inflation

Inflation is a fixed-income portfolio’s silent enemy. Someone who invests $10,000 in 10-year treasury bonds with a five percent coupon per year receives two payments of $250 per year until the bond matures. Unfortunately, inflation can quietly erode the real value of those fixed interest payments.

What if there was a way to make fixed income less fixed? Treasury inflation-protected securities (TIPS) do just that: they adjust an investor’s principal to keep pace with the Consumer Price Index, a common inflation indicator, and investors earn interest on that inflation-adjusted principal.

Conceptually, TIPS yields should equal the real interest rate, which is the nominal interest rate minus the inflation rate, or, simply, a similar unprotected Treasury’s yield minus the inflation rate. This relationship between Treasury and TIPS yields could help investors gauge the market’s expectation of inflation.

Over the course of their seven-year existence, TIPS yielded, on average, 25 basis points per year more than they should have given the measured rate of inflation. The following table shows 10-year TIPS and Treasury yields, the implied inflation as determined by the spread in their yields, the measured inflation rate, and an error column that shows the difference between the implied and measured inflation rates.

TIPS Inflation Prediction Error Table

Over the past two years, TIPS yields reflected a higher implied inflation rate than was measured. Investors inclined to use the spreads between Treasury and TIPS yields to predict future inflation would say that the market believes inflation will rise in the future. Historically, however, spreads between Treasury and TIPS yields were very inaccurate predictors of even just the direction of future inflation.

If an investor interprets the error column in the table above as a measure of the market’s bias toward higher or lower future inflation, he or she would be led in the wrong direction in five of the TIPS’ seven-year existence. The following table shows the predictions based on the error column, and whether each prediction was correct or incorrect in predicting the direction of the following year’s inflation rate.

TIPS Inflation Prediction Table

Note: A version of this article appeared in the March 24, 2004, edition of The Daily Record, a law and business newspaper published in Rochester, New York.