Concerned About Rising Prices? Consider Treasury Inflation-Protected Securities

After hovering under the radar for several years, inflation reemerged with a vengeance in 2021. Prices haven’t soared this fast since the early 1980s, meaning many investors have never experienced such high inflation levels.

Today’s inflation environment underscores the importance of hedging a portfolio’s inflation risk. Treasury inflation-protected securities (TIPS) are one way to do that.

Higher Inflation Likely Will Persist

We believe inflation may be nearing a peak and eventually will moderate. However, we also believe inflation will remain notably higher than before the pandemic.

Several trends will continue to pressure prices:

• Record federal spending and deficits.

• Rising wages.

• Elevated housing costs.

• Supply chain breakdowns.

• Corporate onshoring efforts.

Federal Reserve (Fed) policy also plays a role. As inflation surged in 2021, the central bank held rates near 0%. For most of 2021, the Fed’s supportive stance hinged on the belief that inflation was transitory.

But by their January 2022 monetary policy meeting, Fed policymakers admitted inflation was higher and more persistent than they initially expected. This realization set the stage for the Fed’s rate-hike campaign—and delicate balancing act.

If the Fed raises rates too aggressively, it risks hampering economic and corporate earnings growth. If it tightens too slowly, the Fed risks runaway inflation.

Even Low Inflation Can Do Long-Term Damage

On the surface, the Fed’s goal of an average inflation rate of 2% (or slightly higher) seems relatively low. However, even small increases in inflation can diminish a portfolio’s purchasing power over time.

Consider this: Over the last 25 years, inflation has averaged approximately 2.21%. But that relatively modest rate has translated to a significant loss of purchasing power. For example, at a 2.21% rate of inflation, an item that cost $100 in 1997 would cost $173 today.

How can investors position their assets to avoid lasting damage from inflation? An allocation to TIPS may help.

TIPS: Bonds That Seek to Preserve Your Purchasing Power

TIPS are a class of U.S. Treasury securities designed to help protect investors from the long-term, corrosive effects of inflation. Unlike nominal Treasuries, the face value of TIPS changes along with the inflation rate. As inflation rises, the principal value of the security increases, creating a steadily growing stream of interest payments.

Nominal Treasuries vs. TIPS

At maturity, the TIPS owner receives the original principal value plus the sum of all the inflation adjustments. Of course, the opposite is true in periods of deflation, which would cause the principal value of TIPS and the interest payments to decline.

How TIPS Adjust With Inflation

TIPS Have Historically Outpaced Inflation

TIPS have shown to be an effective long-term hedge against inflation, significantly outpacing the Consumer Price Index over time. In addition to handily beating inflation over time, TIPS have outperformed commodities—also an inflation-hedging asset class—and diversified core bonds.

While many investors have used gold and other commodities as inflation hedges, these assets also have been subject to sharp volatility. TIPS, on the other hand, have historically delivered less volatile performance over time. So along with their inflation-fighting qualities, TIPS may also offer attractive risk-adjusted, long-term performance potential in a diversified portfolio.

TIPS May Fight Inflation With Less Volatility

Cumulative Total Returns (Indexed to 100)

What About Interest Rate Risk?

Because TIPS are Treasury securities, they’re backed by the U.S. government and contain virtually no credit risk. However, like all bonds, they are subject to interest rate risk.

In general, TIPS have the potential to perform better than nominal Treasuries in a rising interest rate environment—if rates are rising along with inflation. The inflation-adjustment feature of TIPS is designed to provide price protection.

Nominal Treasuries don’t have this feature, and their prices typically decline when rates rise. However, if interest rates rise while inflation remains low or flat, TIPS prices could decline.

Consider TIPS When Seeking Inflation Protection

We believe their potential to protect against inflation, generate positive real (inflation-adjusted) returns and reduce risk makes TIPS an attractive component in a well-rounded portfolio.