With concern about inflation rising for some investors, we’ve started to receive questions about Treasury Inflation-Protected Securities, or TIPS. With TIPS, the principal of the bond, the part that’s paid back when the bond matures, is adjusted for inflation (or deflation) as measured by the Consumer Price Index (CPI), which is a form of inflation protection. However, the added inflation protection doesn’t come for free. TIPS almost always offer a lower yield than ordinary “nominal” Treasuries with the same maturity, usually significantly lower.
The Breakeven Inflation Rate
The difference between the yield for TIPS and nominal Treasuries is called the breakeven inflation rate, since if inflation runs higher over the lifetime of the bond, you’ll get a better return from investing in the TIPS; if it runs lower, you’ll get a better return from similarly dated nominal Treasuries. For example, on December 18, 2020, the yield for the 10-year Treasury was at 0.95% and the yield for 10-year TIPS was at -1.00%, according to Federal Reserve data. The difference between them (1.95%) is the breakeven inflation rate.
Since the breakeven inflation rate is determined by market forces, it’s often treated as a market-based measure of inflation expectations. As shown in today’s LPL Chart of the Day and explained above, the 10-year breakeven inflation rate as of Friday, December 18, was 1.95%, roughly in line with the average for the previous 10 years (1.93%).
“The 10-year breakeven rate gives us a sense of what market participants think inflation will be over the next 10 years, and right now markets are saying it will be right around the Federal Reserve’s 2% target—a pickup from the 10-year average of about 1.7% for CPI inflation,” said LPL Chief Market Strategist Ryan Detrick.
When is it a good time to buy TIPS?
TIPS make the most sense as a potential substitute for some holdings of similarly dated nominal Treasuries. As US government bonds, they are high quality, but the trade-off is a lower yield. All else equal, they also have about the same interest-rate sensitivity as similarly dated Treasuries (bond prices fall when their yield rises and rise when their yield falls), although TIPS yields may move more or less depending on changing inflation expectations.
TIPS will outperform similarly dated nominal Treasuries, all else equal, when inflation exceeds the breakeven inflation rate at purchase, currently just under 2% for 10-year TIPS.
The difference between TIPS performance and Treasuries is most heavily influenced by changes in inflation expectations as reflected in the breakeven inflation rate (as opposed to actual realized inflation). TIPS outperform similarly dated Treasuries when inflation expectations rise and underperform when they fall.
With the 10-year inflation breakeven near historical levels but somewhat above historical inflation, we would consider TIPS about fairly valued now relative to nominal Treasuries. If inflation is a particular concern, it would be reasonable to substitute TIPS for some Treasury exposure. It’s important to keep in mind that inflation protection comes at a price, and historically that has kept the returns for TIPS and nominal Treasuries roughly aligned in the long run.
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