With commodities prices surging and inflation pressures heating up in certain sectors of the economy, the financial press is loaded with articles offering advice on how to protect your portfolio from inflation. One of the more common recommendations is to buy Treasury inflation-protected securities (TIPS). This is a strategy we advise against.
It isn’t that we are averse to TIPS. But the problem with buying TIPS today is that yields are far too low and durations on many TIPS and TIPS funds are too long. By example, the yield on the Vanguard Inflation-Protected Securities fund is only 0.36%, and the fund has a duration of 7.6. It is important to recognize that the yield and duration on VIPSX isn’t comparable to the yield and duration on nominal bond funds. The 0.36% yield on VIPSX is the real yield or the yield an investor will earn in addition to inflation. So everything else equal, an inflation rate of 2% over the next year would translate into a 2.36% return on VIPSX.
Unlike the duration on a basic Treasury bond fund, the duration on VIPSX is the approximate percent change in price for a 1% change in real yields. So if the 0.36% yield (a real yield) on VIPSX rose to 1.36%, the price of the fund would fall about 7.6%.
That’s instructive, but why should investors care about the real yield? Isn’t the financial press advising TIPS as an inflation hedge? Indeed they are, but an adverse move in real yields, could cause TIPS prices to plunge. Take a look at our real 10-year Treasury yield chart. Here I am simply taking the historical nominal treasury rate and subtracting the average inflation rate over the previous 10 years. Over the last five decades, the real 10-year Treasury yield has averaged 2.71%. Today, real yields are 0.99% as measured by 10-year TIPS. By historical standards, real yields are low. What would happen to TIPS prices if real yields rise to their historical average? A 1.70% rise in 10-year TIPS yields would translate into an unpleasant 14% drop in TIPS prices. That’s not the inflation protection many investors think they are buying.
Of course, we are assuming an instantaneous rise in interest rates to come up with our 14% projected loss on TIPS. What if it took a few years for rates to rise and during that time inflation accelerated? What kind of a return would 10-year TIPS earn then? It still wouldn’t be pretty. If you assume a three-year holding period, a 1.7% rise in real yields, and inflation of 4% annually, 10-year TIPS would return 1.15% annually over the next three years. That’s far below the assumed inflation rate of 4%.