Last week, inflation was reported at its highest level in 40 years, posting a much stronger rise than expected. But inflation-protected bond funds racked up losses, extending declines since the start of the year. Which give?
In a nutshell, investors are getting a lesson in the dynamics of the Treasury inflation-protected securities market. Just because inflation is high and rising doesn’t mean a TIPS fund will make money. It can easily be the opposite. Often what matters most is what is expected to happen with inflation in the months, quarters and years ahead.
“This is one area where it seems simple and obvious: why not just buy them if inflation rises?” says Eric Jacobson, fixed income strategist in Morningstar’s manager research group. “The answer is that the market predicted it would happen.”
Currently, as inflation numbers heat up, investors also expect the Federal Reserve to take more aggressive action to put out the fire. “With TIPS selling, the market is not reacting to inflation news, it is reacting to expectations of Fed strength,” Jacobson says.
This translates into negative returns on TIPS funds so far in 2022. The iShares TIPS Bond ETF (POINT) is down 4.5% since the start of the year, after a return of 5.7% in 2021.
Among the actively managed TIPS funds, one of the largest, the American Funds Inflation Linked Bond Fund (BFIAX)is down 3.7% in 2022 after returning 3.8% last year.
There is still more for investors to understand in order to get the most out of TIPS in a portfolio, including understanding where TIPS says the expected level of inflation, “real returns” and exposure to changes in interest rates. ‘interest.
How do TIPS work?
Most traditional bonds offer fixed periodic interest until maturity, at which time the owner – whether an individual or a mutual fund – is also repaid the face value of the bond. title. To a large extent, traditional bond yields take account of expected inflation. The problem is that over time, inflation will further eat away at the value of that bond. This is particularly a problem for long-term bonds.
TIPS solve this problem by adjusting the amount due to investors based on changes in the consumer price index. This means that investors are paid more as inflation rises. If the CPI increases by 5%, the amount investors receive will also increase by 5%. (You can find a fuller explanation of TIPS and TIPS mutual funds here.)
TIPS have been around for about 25 years, but the current inflation spurt is the worst since the early 1980s. of supply caused by a pandemic following a recession. This creates an unprecedented environment for TIPS investors to date.
In 2021, TIPS was the best performing major sector in the US bond market. The Morningstar US TIPS Index rose 5.7% last year, while the broader Morningstar US Core Bond Index lost 1.6%.
Most of this TIPS rally took place in the second half of 2021 as the recovery from the pandemic recession took hold and the first signs of supply chain concerns emerged. This has led to a flood of money from investors into TIPS and inflation-protected fund strategies more broadly.
The Fed shifts gears
The change in performance in early January for TIPS coincided with a decision by the Fed to take more aggressive action to raise interest rates and to withdraw the bond purchases it had made to pump money into the banking system during the recession. Since the start of the year, the American TIPS index has lost 4.2%.
“I would put it on the shoulders of policy reversal by the Fed and other central banks,” says Steve Rodosky, managing director and portfolio manager at PIMCO. “Expectations have gone from nothing or very little on the policy rate front in 2022 and 2023 to more than four hikes for the 2022 calendar.”
One way to see the impact of changes in expectations around inflation and the Fed is to follow the so-called equilibrium rate. This rate – the difference between the nominal 10-year Treasury yield and the yield on 10-year Treasury inflation-protected securities – represents the market’s expectations of what inflation will be like in 10 years.
Over the course of 2021, the 10-year breakeven rose from 2% to 2.7%, reflecting expectations of higher inflation. The 5-year balance stood at 2% at the start of the year to peak at 3.2% in mid-November. When the December and January inflation reports were both warmer than expected, they showed that inflation is proving to be more rigid than many economists had expected. At first glance, this would have suggested continued upward pressure on inflation expectations.
But that was not the case. The 10-year breakeven fell to 2.4% and the 5-year to 2.8%. While still up from a year ago, these levels are heading back towards the Fed’s long-term inflation target of 2%.
These readings show that “high inflation expectations aside, the world expects a very subdued inflation environment going forward,” says Rodosky, who is manager of the $12 billion Pimco Real Return Fund. (PRICE).
For TIPS, these expectations of lower future inflation translate into expectations of lower future adjustments to inflation and, therefore, lower prices.
Headwinds Fto higher yields
Another headwind for some TIPS investors has been the rise in regular Treasury yields. The yield on the 2-year US Treasury bond jumped to almost 1.4% from 0.7% at the start of the year, while the yield on the 10-year bond reached 2% last week, from 1 .5%. Both of these changes are substantial movements over a short period of time. Despite inflation protection, an overall rise in the level of interest rates will continue to feed through to the TIPS market, putting downward pressure on prices.
For this reason, Jacobson says that when bond fund managers and traders want to hedge against – or bet on – an impending rise in inflation, they will use short-dated TIPs that are less affected by changes in interest rates. ‘interest. For example, the TIPS bond maturing in July 2022 has risen in value so far this year, even as longer-dated TIPS have sold off, Jacobson said.
Another component was an increase in so-called “real yields”. Basically, a real return is a bond yield minus the rate of inflation. Since the start of the pandemic, real returns on TIPS have been negative. This means that once investors factored in the effects of inflation on their returns, even with the inflation protection offered by TIPS, investors would essentially lose money on their investment.
In other words, after inflation, “the premium you paid for this bond is so high that you’re not going to earn enough income by the bond’s maturity to offset it,” says Jacobson.
What does quantitative tightening mean for TIPS?
One of the reasons real TIPS returns have been negative is because the Fed has been buying huge amounts of US Treasuries as part of its effort to prop up the economy, an action known as quantitative easing, or QE.
“You had investors flocking into the asset class ‘seeking inflation protection,’ Rodosky says, ‘seeking the same bonds that the central bank was already buying.’
Recently, real yields have increased. In addition to changing inflation expectations, the Fed’s withdrawal from the market removes a massive source of demand that had pushed yields lower. Fed officials began discussing reducing the number of bonds held — the opposite of QE — a step known as quantitative tightening. “As of 2020, the marginal buyer of a lot of fixed income has been the Fed,” Rodosky says. This leaves it up to traditional market players to set prices and they demand higher returns.
What’s next for TIPS?
The question for investors begins with the role TIPS play in a portfolio. If it’s just part of a longer-term asset allocation, as it would be, averaging the dollar cost over time means you don’t have to worry about current valuations.
But for a more tactical approach, the question revolves around what TIPS is currently pricing for future inflation versus what an investor expects to happen. “You want to buy TIPS when the equilibrium rate is below your inflation expectations,” says Jacobson.
Based on break-even rates, the TIPS market is priced at 2.8% inflation over the next five years.
Pimco’s Rodosky sees an opportunity for investors to buy insurance against the possibility of inflation being even more rigid than it has been. “The market is priced for a fairly quick reversal in CPI levels to where we end 2022 and enter 2023 in the 2.5 range,” he says.
These expectations are based on the idea that once supply chain issues are resolved, inflation trends will revert directly to pre-pandemic dynamics where globalization has driven down wages and costs and austerity. budget in major economies has limited economic growth, Rodosky said. Another result could be that the pandemic has changed the history of globalization and that households have considerably more pent-up demand over the past two years than accounted for. Rodosky says if that’s the case, “the cost of insurance is pretty low right now. ”