Inflation TIPS for Fixed-Income Investors
What happens when you combine the tipping point of two deflationary forces—globalization and demographics—with a pandemic, epic supply-chain disruptions and an invasion in Europe? Inflation of a magnitude not seen since the 1970s. Some of the contributing factors may be transitory, but not all, and lingering inflation is likely to be higher than before. How should bond investors adapt?
Inflation Is a Process, Not an Event
For decades, strong deflationary forces held sway over the global economy. Demographics shifted as the working-age population swelled and women’s participation in the labor market increased. Workers from China, India and other emerging-market countries effectively doubled the global workforce. Combined with technological innovations and associated productivity enhancements, the larger workforce helped moderate price growth.
Until very recently, the US economy had been enjoying what felt like an economic party— inflation was moderate, the Fed was spiking the punchbowl with easy money, interest rates were low and growth investments danced with lamp shades on their heads.
But tides turn. The deflationary demographics tailwind is abating. Baby Boomers are edging into retirement, and US family size is dropping. And there are no sizeable pockets of workers unconnected to the global supply-chain. Globalization isn’t just slowing; it’s shifting into reverse. A call to bring supply-chains back onshore began even before the pandemic revealed the vulnerabilities of extended supply-chains.
Add to this pandemic-related stimulus. Consumer savings increased as they had limited opportunities to spend, especially on services. Factories closed for population distancing, creating backlogs that could take years to clear. And resulting supply chain disruptions left some retailers with sparse inventory.
This shortage of available goods combined with pent-up demand has triggered tangible widespread inflation. Durable goods prices have soared by almost 17% year over year through December 2021. Services prices are also increasing—albeit more slowly—as consumers emerge from pandemic isolation. And labor costs are rising, as many workers can’t or don’t want to return to the traditional labor force.
The Fed’s task is to take away the punchbowl before inflation gets out of hand by raising interest rates, but with setbacks from the pandemic, the timing has been tricky. A year ago, the market expected inflation of 2.4% annualized over the next five years. Today, the market is pricing in over 3.25%. And Russia’s invasion of Ukraine is pushing inflation expectations even higher, driven by soaring oil and grain prices. The conflict could increase the duration and intensity of inflation.
Inflation can bruise traditional stock and bond portfolios’ real (inflation-adjusted) returns. Historically, when inflation spiked, the 10-year rolling real return of a 60% stock / 40% bond portfolio turned negative (Display).
Fortunately, investors can take action to soften the effects of inflation on their portfolio.
Portfolios Should Evolve with Inflation
As inflation evolves, so should investors’ portfolios. During 2021’s early inflation, the Fed was accommodative, growth was abundant and higher-spread sectors like high-yield corporates benefited. But when fighting inflation becomes the Fed’s priority, it’s time for investors to consider adjustments to their portfolio. Today, that means positioning for an environment of higher inflation and lower growth, where Treasury Inflation-Protected Securities (TIPS) can help investor portfolios.
TIPS protect against inflation in two ways. First, the principal value of TIPS is indexed to inflation. When inflation increased by 7.5% in 2021, so did the principal value of TIPS. Second, TIPS’ coupon payments are also inflation-adjusted, with payments based on the inflation-adjusted principal value of the TIPS multiplied by the coupon rate. TIPS also maintain the defensive components of Treasuries, should growth expectations decline.
The Treasury yield minus inflation expectations equals the real yield on the corresponding TIPS. In more normal times, the real yield is positive. Today, however, with yields low and inflation high, the entire TIPS curve is trading at negative real yields (Display).
Real yields for short-term TIPS are especially deep into negative territory, a product of the recent inflation spike. When inflation runs hot, its risk of it getting even hotter rises, because consumers fear higher future prices and shift their purchases forward. Over the longer-term, however, investors expect inflation to crest in the next few years, and they have priced a return to more normal long-term inflation of 2.3% into the market. This makes inflation protection more attractive than usual, despite negative rates. Historically, in times of above normal and rising inflation, TIPS have outperformed US Treasuries and may be a sensible replacement for them, combining the safety of Treasuries with upside inflation protection.
But TIPS alone are not the answer. Investors still need more yield to help protect from diminishing purchasing power, given the negative real yield starting point of TIPS. One solution is to replace the Treasury allocation in a multi-sector bond portfolio with TIPS. The multi-sector portfolio provides a more appealing risk/return profile, in addition to a yield cushion. Corporate bonds and securitized debt boost portfolio yields and are less sensitive to interest-rate risk—an important feature when rates are rising.
Above all, complicated times require nimble thinking and agile reactions, because the “right” response to inflation shifts with the prevailing winds. That’s why our best tip for fixed-income investors is to remain vigilant as world events evolve.
- Ronit Walny
- SVP/Head of Fixed Income Product Management—Global Business Development-Fixed Income-NY
- Janaki Rao
- Portfolio Manager and Head—Agency Mortgage-Backed Securities Research