Home > Library > Stable Times > Volume 7, Issue 1  

New Kids on the Block: TIPS

An increasing number of TIPS (Treasury Inflation Protected Securities) fund offerings, combined with recent double digit returns, has fueled interest in, and allocations to, TIPS within the defined contribution marketplace.

In this article, we explain the attraction of TIPS, how they compare to nominal bonds, and how they perform in different market environments. This may help the reader better understand how TIPS can be positioned within the array of defined contribution options offered to participants. We also explore the important question, "Do TIPS Compete with Stable Value?"

The Attraction of TIPS

Their face value is adjusted daily to reflect the changes in the cost of living (CPI) that are reported by the Bureau of Labor Statistics each month. This indexation is structured to protect an investor's capital by returning the inflation-adjusted face value to the investor at maturity. In addition, the TIPS coupon payment is calculated on the adjusted face value, ensuring that the stream of interest payments increases or decreases with the cost of living. While the face value and interest payments would be adjusted downward if the CPI fell (that is the economy were to experience deflation), the Treasury guarantees that the maturity value can never fall below the original face value.

The most recognized benefit of holding TIPS is that they provide an inherent hedge against inflation, thereby allowing investors to protect their purchasing power. This link to inflation is why TIPS are often called "real return bonds". TIPS, like other Treasury bonds, are backed by the full faith and credit of the US government and so are protected from default risk. Other attractive characteristics, such as relatively low price volatility and low correlations to other asset classes, led TIPS to be considered as an excellent portfolio diversification tool and an alternative asset class from other fixed income and equity securities.

Outstanding TIPS issuance has grown to over $167 billion in market value as of December 31, 2002. According to the NY Fed, average TIPS secondary market trading volume exceeds $2 billion per day and has been growing. With the Treasury Department committed to future issuance of TIPS, it is expected that the size and breadth of participation of the US real return bond market will continue to grow. In addition, many countries such as United Kingdom, Sweden, France, Canada, Australia, and New Zealand have been active issuers of inflation-indexed bonds. This new global issuance has broadened the global real return markets and has diversified real return relative value opportunities.

How Do TIPS Compare to Nominal Bonds?

Unlike nominal, or non-inflation-adjusted bonds, TIPS provide two sources of return: (1) a daily principal accrual that is based on the CPI, and (2) fixed rate coupon payments that are fully indexed for inflation as it accrues on the adjusted face value over time.

It works like this: Suppose you invest $1,000 in a new 10-year TIPS with a 2% coupon rate paid annually. If inflation is 3% over the next year, the face value will grow to $1,030 reflecting the increase in cost of living. Meanwhile the annual interest payment would be $20.60, or 2% (the coupon rate) of the adjusted principal. If inflation remains at 3% for each year, in the 10th year (assuming inflation remains at 3%), the final interest payment would be $26.88, and the investor would receive $1,343.92 in adjusted face value, which would have an inflation-adjusted value of $1,000.

As a result, TIPS, if held to maturity, offer what is known as a fixed "real" rate of return-the actual return of an investment after inflation is taken into account. A traditional bond, on the other hand, offers a fixed "nominal" return. It maintains a fixed face value until maturity, with no adjustments for inflation. For example, if you're receiving a 5% return on a traditional bond and inflation is rising at 3%, your "real" return is 2%. Unlike TIPS, the 2% real return the Treasury offers is not fixed but falls or rises inversely with changes in the inflation rate. For example, if inflation turns out to be 4%, the actual "real" return (ex post) for the nominal bond drops to 1% over its life.

Investors should be careful when comparing TIPS against similar maturity Treasuries, as real yields do not move lockstep with conventional yields. Nominal yield changes consist of three factors (1) real yield changes, (2) changes in inflation expectations, and (3) changes in the inflation risk premium. In contrast, only changes in real yields influence TIPS prices. As shown in Figure 1, the 2008 TIPS had low relative volatility to a comparable maturity treasury. Over the last two years, however, its volatility has begun to move more inline with that of its conventional counterpart. From this, we can infer that inflation was the primary catalyst behind earlier nominal yield movements. In contrast, recent yield movements have been driven more by changes in real interest rates.

See Figure 1.

When estimating the sensitivity of TIPS to changes in nominal interest rates, one way for risk managers to account for the observed muted real interest rate volatility and less than perfect correlation between TIPS yields and nominal yields is to adjust TIPS durations. Such TIPS durations are known as "effective" durations. They are extremely useful when combining TIPS and nominal fixed income securities, as they describe how much sensitivity to nominal rate changes TIPS embody. In particular, the concept of effective duration incorporates more accurately expected price sensitivities, based both upon previously observed and upon forecasted yield relationships between Treasuries and TIPS, than naively calculated formulaic durations based simply on a TIPS price, coupon, and maturity.

So how is such theory put to work? To compare TIPS risk to that of nominal bonds, an investor needs to predict TIPS expected sensitivity to changes in nominal interest rates. This effective duration is calculated by multiplying the standard mathematical duration by a "yield beta" that has typically varied between 0.20 and 0.80. Unfortunately there is no industry standard number to use for a yield beta, rather it falls upon the shoulders of risk managers to forecast.

Although TIPS are indexed to inflation and have the full faith and credit of the US Treasury backing them, they are not immune from fluctuations in market value. Just as the price of a traditional nominal bond fluctuates based on changes in yields, the mathematics for TIPS is essentially identical, except that it operates on real yields and real durations rather than nominal yields and nominal durations. In both cases, the bonds' duration, applied to the change in rates (nominal rates in the case of the nominal bond, real rates in the case of TIPS) is an exact predictor of price change.

How do TIPS Perform in Different Interest Rate Environments?

A key to understanding how TIPS are valued is something called the break-even rate of inflation, which is calculated by subtracting the TIPS yield from the nominal yield of a similar maturity conventional Treasury. If the break-even rate is one percent, for example, it means that if the CPI rises by more than an average of one percent per annum over the remaining life of the security, the TIPS will outperform. If the CPI rises more slowly, the conventional Treasury will outperform.

Therefore, the break-even inflation rates generally reflect market expectations for future inflation (plus, theoretically, an inflation risk premium that compensates the holder of a conventional Treasury for the imprecision of such expectations). So it is only an increase in inflation above what is expected that will result in TIPS outperforming similar maturity nominal bonds.

The chart below shows potential anticipated performance of TIPS in different interest rate environments. The best environment for TIPS is a falling interest rate environment that provides capital gains combined with high inflation that will increase income and principal. The worst environment is a rising interest rate environment that causes capital losses combined with low inflation that will reduce expected income.

See Figure 2 - Factors Affecting TIPS.

Do TIPS Portfolios Compete with Stable Value?

As TIPS funds have gained popularity and are considered for inclusion in the fund line-up of many defined contribution plans, there has been increasing discussion as to whether TIPS funds compete with Stable Value funds. When we discuss "competing" funds, we do not mean simply an investment option that may cause the amount invested in the Stable Value fund to fall. Every new investment option can have that effect.

"Competing funds" are generally considered to be funds with similar characteristics to stable value funds that may provide arbitrage opportunities for participants to transfer out of stable value when interest rates rise, posing risks for remaining stable value participants and the issuers of the book value contracts. Historically money market and short-term bond funds have been considered competing funds. Protections, such as transfer restrictions (or equity washes), have been required to protect both book value contract issuers and stable value participants.

Some book value providers suggest that TIPS should be considered competing funds. Their arguments generally center around the perceived similarities of TIPS funds with stable value and the potential that in a rising rate scenario the returns on TIPS funds may be more attractive than Stable Value funds which will lag market interest rate movements. This disengagement between yields could lead investors to transfer out of Stable Value and result in further lags (or even a decline) in the stable value earnings rate for participants who remain. This activity could increase the risk that book value providers could have (albeit limited with participating wrap contracts) to absorb market to book deficits.

Other arguments, which suggest that TIPS should be considered competing funds, include:

• TIPS are a conservative investment option since they are issued by and have the full faith and backing of the US Government. Investors therefore will perceive them as "safe" funds and will not be able to fully understand the differences between TIPS and stable value funds.
• TIPS funds have less price volatility than nominal treasuries and other fixed income funds (with similar mathematical durations), making them appear similar to stable value funds. Ex-post TIPS effective durations have sometimes been similar to short term bond durations (which are considered competing), and have similar volatility and interest rate risk.
• TIPS preserve principal over their life which is especially valuable when inflation levels are unexpectedly high - a feature that leads them to appear to be similar to stable value.
• Like stable value, TIPS have low correlations to other asset classes and can be used to reduce overall portfolio volatility.
• In their relatively short existence, TIPS have rarely generated negative returns over quarterly periods (coinciding with what participants see on their statements).

On the other hand, there are several arguments as to why TIPS should not be considered competing funds, and therefore should not require transfer limitations. Some of these include:

• TIPS are only designed to provide a fixed real return over their remaining lifetime not every period.
• TIPS have generated negative monthly and quarterly returns. As an example, since March 1997, the Lehman US TIPS Index have posted a negative return in 18 monthly periods, 9 quarterly periods, and 1 six-month period. This compares negatively to stable value, which has protected principal through all periods.
• The return volatility of TIPS (as shown below) is materially higher than a money market fund or stable value fund. As an example, the return volatility (as measured by standard deviation) of a TIPS Index compared to representative book value and stable value indices is shown below:

March 1997 through December 2002
	Annualized Returns	Annualized Stnd. Dev.
Lehman Global Real US TIPS Index	7.75%	3.88%
Lehman Aggregate Index	8.03%	3.40%
Hueler Stable Value Index	6.23%	0.09%
Lipper Money Market Index	4.29%	0.45%

In fact, the volatility of TIPS has been similar to the volatility of the Lehman Aggregate Bond Index, and funds managed to this index are generally not considered competing funds. However, over this time period, interest rates have generally declined, giving rise to the positive returns on TIPS as well as various other fixed income asset classes.

To further amplify this point, the bars in Figure 3 show the monthly returns for the TIPS and Lehman Aggregate indices. As you can see, the numbers fluctuate significantly. For comparison, we have shown the monthly returns for a wrapped Lehman Intermediate Aggregate Index for the same time period (represented by the smooth line in Figure 3). This chart looks very similar to the chart frequently used to show the benefits of wrapped versus unwrapped bonds, illustrating the volatility of unwrapped bonds and how the presence of a wrapper can smooth that volatility. As with unwrapped nominal bonds, the vast peaks and troughs in the chart show that TIPS are subject to price fluctuations as interest rates change, and that participants investing in TIPS can lose money.

See Figure 3.

• TIPS fund typically are managed versus benchmarks that have very long formulaic durations (typically 8 to 9 years). While the effective duration to nominal rate changes will be somewhat lower than this because of the lower volatility of real yields, the ex post effective duration of these benchmarks are almost always longer than the 2.5 year duration threshold normally used to determine if nominal bond funds are considered competing.
• While relative yield advantages can give rise to true arbitrage opportunities between money market and stable value funds, the same is not true for TIPS funds in relation to stable value funds.
  
  Yield is a good predictor of future expected returns for money market and stable value funds, which have little or no price volatility. As a result, participants should be rewarded for moving to the higher yielding option. Similarly, to the extent short-term bond funds hold similar investments as those underlying stable value funds, an arbitrage opportunity exists based on the presence of accounting differences (market value versus book value accounting treatments). A participant can expect to be rewarded by choosing the option that trades at a higher yield. However, this is not the case for unwrapped nominal bonds or TIPS, which have significantly more volatile returns relative to stable value (as shown above). Funds with inherent price volatility cannot be arbitraged based on yield. As an example, even when TIPS are performing well due to increased expectations for inflation, the reported yield of a TIPS fund may be falling, or may even be negative. Differences in TIPS and stable value fund returns are not determined solely by yield or accounting differences. TIPS returns are a function of complex relationships relating to inflation, real yields, real growth, and investment sentiment - and unlike yield and accounting differences, these differences cannot easily be arbitraged.
• Some TIPS funds can hold securities other than TIPS, which can further increase the return volatility of the funds. They may hold Corporates, Emerging Market, Non-US $, bonds, mortgages, private placements, and below investment grade securities. Some funds can also utilize leverage.
• Plan sponsors can influence how participants perceive TIPS funds. An accurate description of the risk and return characteristics of TIPS funds will clearly highlight the potential short-term volatility of TIPS funds. The features of inflation protection versus principal protection can be clearly highlighted, and the potential for negative returns explained, to help to differentiate these options for the investor.
• Requiring an equity wash may be confusing to participants who will then look at TIPS as a potential substitute for, rather than complement to, a stable value option.

TIPS funds continue to be considered for defined contribution plans, and it seems they are very popular selections by employees who can access them through a brokerage "window" option in the plan.

As such, there will clearly be more discussion of these arguments.

Read Next: Stable Value Gains In College Savings Market