This eighth and final part wraps up my thoughts on the role of TIPS in a Risk Parity portfolio. What did I learn about the asset class? A lot, and here are eight summary observations. Next question: Will I be changing my investing strategy in response? Hmmm…
This is the final post in my "RPC Investigates" series on Treasury Inflation-Protected Securities (TIPS), where I’ll bring together and summarize what I have learned from this deep dive. Here are the previous installments, along with their number in the series. In the main text below, you’ll see them referred to them by this number:
- The first post introduced them and what I'm trying to do in this deep dive.
- This was a Risk Parity Basics post explaining TIPS from the ground up.
- Here I differentiated between stand-alone TIPS and TIPS in funds.
- This was a Risk Parity Resources post that assembled five sources for more learning on TIPS.
- Now on to the backtests: this post did two long-term backtests on TIPS funds, back to 2001 and to 2009.
- Next, this series of backtests focused on TIPS fund performance during inflationary stretches.
- In this explainer, I looked at stand-alone TIPS and compared them to I Bonds and to regular, nominal Treasury bonds.
Having looked at TIPS from a variety of angles during this series, I’m now ready to organize some of the points before I try to fully answer the central question regarding the place of TIPS in a RP portfolio.
Please do take the following perspectives with a grain of salt. The more you dive into something, the deeper you realize the topic actually is, as if the swimming pool gets deeper with every foot you submerge yourself. TIPS are no exception, and I wouldn’t say my thoughts on them are now settled or closed off to new learning.
With that disclaimer out there, here are eight of my not-that-hot takes on TIPS:
Take #1: Be Sure to Differentiate between Stand-Alone TIPS and TIPS in Funds
I started off this line of inquiry knowing they’d likely be quite different, but not knowing exactly how different. As you know if you’ve been reading along, the basic mandate to match inflation is certainly true if you are a buy and hold investor in stand-alone TIPS and keep them until maturity.
When you begin to consider trading them on the secondary market or put them all together into a vehicle that can be traded easily, though, they act more like a regular bond fund. Not that that is good or bad, mind you, but you should know what you’re getting. When talking with someone about TIPS, I would advise clarifying terms first and specifying which type of them is being discussed (3).
Take #2: TIPS Funds Are A Lot Like Other Bond Funds, For Better or Worse
Continuing from above, when you put TIPS in a fund such as TIP, LTPZ, STPZ or equivalents, you’ll find yourself with a fund that acts much like a nominal bond fund of a similar duration. All bonds carry “duration risk,” the possibility that a change in interest rate for newly issued bonds will impact the value of existing bonds, which is a function of how long the bond has until maturity and the original interest rate.
In TIPS funds, as Steven Hou points out, this risk dominates the sales price when TIPS are sold before maturity. By the way, you could argue that stand-alone TIPS that you are holding until maturity experience changes in value as well, it’s just that you don’t notice since you’re holding them regardless (1).
The lesson for RP investors is that you probably shouldn’t expect much out of TIPS funds beyond what you’d expect from a regular bond fund. In the four inflationary stretches I backtested, TIPS funds did about the same as nominal bonds and gave no apparent signal that any inflation-protection was happening. This doesn’t make them a bad investment, but investors in TIPS funds should go in with low expectations (6).
Take #3: Over Long Timeframes, TIPS Funds Don’t Offer Much Diversification Benefit
In the backtests, TIPS didn’t offer much of a diversification benefit compared to nominal Treasuries. When TIPS did well, it was because they offered additional return in line with what equities were already doing. When comparing their correlations to other assets in the Golden Butterfly portfolio, TIPS were more correlated to equities than equivalent nominal bonds. For example, since 2009, Long-term Bonds (TLT) were slightly negatively correlated to equities, at -.25, while Long-term TIPS (LTPZ) were slightly positively correlated over the same time period at .21 (5).
The key reason for maintaining an allocation to Long-term bonds in a RP portfolio is as a diversifier, not really a return driver, so to see Long-term TIPS not provide much of this was eye-opening.
Take #4: TIPS Funds Haven’t Actually Done That Great In Times of Higher Inflation
We would especially hope for a diversification benefit during times of heightened inflation, but TIPS funds don’t seem to deliver here, either. I tested various inflation periods and the most noticeable thing, much like the dog that didn’t bark, is that there wasn’t much to notice. They just don’t do much: no “pop” in prices that can buoy a floundering portfolio when inflation strikes; no zag when your portfolio zigs (6). I came to the same conclusion back in April 2022 when I looked at TIPS performance amongst other supposed inflation protectors.
In their defense, it's hard to say categorically what does work as an inflation hedge. Commodities have at times, but not always (6). UPP, the Invesco Dollar Bullish fund, has done great recently, but it hasn’t always been the answer for inflation, either. The stagflation quadrant in Dalio’s simple model continues to be the trickiest of the four to match with appropriate assets. I do wonder if some of the enthusiasm out there for TIPS is done with the hope that the search for a stagflation-protected asset can now be called off, but as I found with my simple tests, I don’t think we’re there yet (2).
Next Level Life doesn’t think so, either:
Take #5: When It Comes to Stand-Alone TIPS, I’d Treat Them More Like A Better Version of Cash
The observations above apply to TIPS funds, but what about stand-alone TIPS that you hold to maturity? Yes, these are better and will protect against inflation, as they promise. Those offer a real return above and beyond whatever the Consumer Price Index (for urban consumers), and perform as advertised if you just let them do their thing.
But…and this is a big but… I would classify this as something you’d want to do separate from a main Risk Parity portfolio. I’d approach them more like cash, or using a term I made up a few weeks ago, “solid” cash, which means something with the stability of cash but where you give up on some of the liquidity in exchange for a higher expected return. “Solid” cash would not be suitable for an every day emergency fund where you’d need immediate liquidity, but if you had a separate rainy day fund as a backstop to that, or else had predictable liabilities in the future that you wanted to match, then stand-alone TIPS might make sense (7).
In this way, I consider TIPS in the same category as Series I Savings Bonds or CDs, and preferably as part of a laddering strategy where I could have some measure of liquidity but with slightly higher returns (3, 7).
Take #6: The Biggest Drawback to Stand-Alone TIPS is Their Tax Inefficiency
Of these options for “solid” cash, though, stand-alone TIPS are probably the least tax-efficient. Primarily, there is the issue of “phantom income” - the face value of the TIPS adjusts to keep up with inflation, but this extra added value is taxed the year it happens. This is in addition to the normal taxation of the interest payments you would receive (3).
You’ll typically see commenters recommending stand-alone TIPS in a tax-advantaged account such as an IRA, since then you wouldn’t have to bother with the phantom income. In my view, though, the expected return of TIPS is far below what I’d like to protect in my limited amount of IRA space. If you’ve got only $6,500 of IRA contributions to protect per year, I’d prefer to protect asset classes that would generate more capital gain in need of protecting, such as small-cap value (7).
Take #7: Stand-Alone TIPS Are, At Best, a “Tactical” Asset Class.
Since they are essentially an enhanced version of cash and tax-inefficient, I don’t think I’d just have a consistent allocation to stand-alone TIPS but would instead buy them on a case-by-case basis when they seem to make sense. You’re not missing out on much by holding them through their fallow periods when inflation isn’t a concern, well, other than the extra taxes.
When inflation does look like it’s becoming a problem, then you might want to jump into stand-alone TIPS at that point. Then again, you might not, as you could also put money into Series I Savings bonds (I Bonds, for short), which offer similar benefits. I Bonds protect against inflation by adjusting the interest rate, not the principal amount, so there is no “phantom income.” Your interest rate (in six month chunks) is also known with I Bonds, so they might be a good choice if you think an inflation spike is temporary (7)
There are some downsides to I Bonds, however, and times when TIPS might make more sense. There is an annual limit on I Bonds and a lock-up period of one year. I Bonds cannot be re-sold on the secondary market, only redeemed back to the Treasury, so they are definitely less flexible compared to TIPS. Since I Bond interest rates are set in six-month increments, TIPS might offer more peace of mind - you’d know it will match inflation over the long-term without having to worry about the short-term (7).
In short, I’d think of TIPS in this tactical way, assessing whether they are the best choice at a given time and comparing them with other similar options. There are more ins and outs to this decision, so if interested, you may want to consider this helpful explainer from Jennifer Larmer.
Take #8: TIPS Likely Would Have Been Great During the 1970s (but that may not mean all that much!)
TIPS began in 1997, but really started as a response to the biggest financial problem of the 1970s: stagflation, which is high inflation in a declining (or at last stagnant) economy. Some of the support for TIPS now comes out of the understandable urge to be sure to have the right elements of your portfolio in place in case stagflation comes back again.
There is evidence to say that would be wise. While we can’t know for sure how they would have done, backward estimations of hypothetical TIPS in the 1970s are quite positive. Edward Qian pegged their real return at 3% over the decade, whereas all other major asset classes (except for commodities, which returned almost 14% in real terms!) lost out to inflation (4).
That being said, I do wonder if the experience of the 1970s has been a lesson that the Federal Reserve has learned from, and whether the 1970s would repeat itself in the same way. In the 1970s, the Federal Reserve was unable to get a hold of inflation until they essentially went nuclear, hiking interest rates high enough to kill the economy, throw millions out of work but also finally deflate prices. This provides a blueprint for how the Fed might respond when the specter of inflation appears again, as we saw with 2022. The Fed perhaps was late in responding, but had no problem assuming a hawkish stance after a few months.
Of course, there is always the possibility that the Fed might want to fight stagflation through interest rate hikes, but that they gain no traction in doing so. After all, the Argentine Central bank learned lessons from the 1970s, too, but their best efforts typically have not been enough. Even if the desire is there, the ability to end stagflation might not be and so we could see a repeat of that fateful decade.
So, if someone were to want to hold TIPS because they explicitly feared and anticipated another 1970s, that would make sense, though my own views are a bit different. I’ll stick with long commodities and managed futures, and buy I Bonds or stand-alone TIPS to supplement those at particular times. A “perfect storm” for TIPS might well form again, but there may be other better boats to deal with it.
To return to our central question - do TIPS deserve a place in a Risk Parity portfolio?
Simple answer: no, not really.
A more nuanced answer has two components:
- Stand-alone TIPS may be a good fit for certain investors at certain times, but should be compared with I Bonds or other similar assets. Buying and holding is the best way to ensure that you actually get inflation protection, though you should be aware of their tax inefficiency as well as the existence of alternatives that may be more suitable.
- TIPS in funds, meanwhile, are a very different sort of asset, and one that will likely be disappointing for the ETF-focused investor. TIPS funds act like regular bond funds, and aren’t necessarily bad, but are underwhelming and haven’t actually protected investors from inflation. I looked at them in long timeframes and then over shorter periods where I was able to use perfect hindsight to guess the right times to buy and sell. Even if you could have timed them perfectly, TIPS funds didn’t live up to their name.
As for me, my eight long posts into TIPS will trigger no substantive changes, which honestly is a bit disappointing. I was hoping for something more like what I learned in the REIT series. In that case, I made some changes in my test portfolios and even with my personal portfolio. In my research then, I found that a Utilities ETF was likely to be a better choice over a REIT index ETF, and so made the choice to reallocate some of VNQ’s allocation to VPU. For my personal portfolio, I found that semidirect real estate investing through Groundfloor had some promise, so I expanded my account there. I liked the process of my research actually leading somewhere.
With TIPS, though, I don’t see much reason to deviate from what I was already doing: holding some money in I Bonds to take advantage of higher interest rates and shunning TIPS ETFs in test portfolios and personal holdings alike. Oh well.