Risk Parity Basics: Explaining TIPS from the Ground Up

First post in the series on Treasury Inflation-Protected Securities (TIPS) is this "basics" article to make sure we're all on the same page. I’ve curated some good video explainers then added some Risk Parity-specific thoughts on TIPS at the end.

TIPS - the basics of the basics

Rather than reinvent the wheel, I’ll just share the clearest, simplest video explanation of TIPS I could find:

…as well as the simplest write-up I could find, which incidentally houses a great two minute video explanation of TIPS, as well:

Treasury Inflation-Protected Securities (TIPS) Explained
Treasury Inflation-Protected Securities (TIPS) are bonds that offset the effects of inflation by adjusting the value of the principal.

One point to reiterate is that you can purchase TIPS in three ways: 1) directly from the government, in 5, 10, and 30 year durations; 2) on the secondary market through your brokerage, or 3) through a fund, either mutual fund or ETF, that packages various TIPS together. These can be funds of various maturities, or concentrated in short- or long-term TIPS (in the form of TIP, STPZ and LTPZ, respectively). As I’ll explain in a future post, the way TIPS are held does matter quite a bit for a portfolio.

How Do TIPS Work?

Again, better go to the great work already out there, so here is the best explainer on the mechanics of their yields and how they adjust for inflation:

That video is great for showing how the interest payments a TIPS holder gets changes over time, since the way TIPS function differs from the norm. Here is a comparison with regular US Treasury bonds.

Origin of TIPS and Connection to Risk Parity

For most asset classes, you don't need a history lesson as part of an explainer, but in this case, one is in order: TIPS in the United States came about because of the advocacy of Ray Dalio, the O.G. of Risk Parity, back in the 1990s. Similar vehicles had been available in Europe, and Dalio became a vocal proponent of the US Treasury offering something for inflation-anxious investors in the States. They started in 1997, and now make up about ten percent of the $20 Trillion dollar Treasury market.

Theoretically at least, TIPS have promise as one of the few assets that would gain value in a stagflationary economic regime, and so solve a key problem for investors wanting to prepare for all four possible economic regimes: inflationary growth, deflationary growth, stagflation and recession. In Dalio’s formulation, there are two criteria to examine to see what regime an economy is in: economic growth and then inflation. For each criterion, there are two variables: the performance is rising above or falling below expectations. This creates a kind of Punnett Square for understanding the economy:

For Dalio and others with a Risk Parity approach, the next step is identifying what assets will thrive in each regime, and then after that, balancing those assets so that the portfolio is prepared no matter what situation the economy is in. The problem has been that three of the four squares are rather easy to fill with appropriate assets (equities and commodities, for example, if the yellow square; long duration Treasury bonds in the green; and just about anything will work in the blue), but finding something to succeed in stagflation has been hard.

Diversion: for more on this, you may like my write-up of Dalio’s ideas here, or else here from the man himself explaining the theory behind Risk Parity.

Stagflation defined the 1970s, probably the toughest decade for investors since the Great Depression, as nothing seemed to work. Better said, even assets with high growth rates in nominal terms experienced low real returns when compared to inflation, meaning that just about everything you invested in decayed. Of course, not investing wasn’t an option either, as cash left under the mattress didn’t even have piddly nominal returns to counter-balance inflation. Stagflation is thus the Bermuda Triangle of the real economy and of investment portfolios.

Here is a great explainer on stagflation and how things in the 2020s may or may not resemble that troubling decade:

TIPS to the Rescue

The idea behind TIPS is that they are the perfect asset should stagflation re-appear. Because the coupon payments are linked to the inflation rate, you can guarantee yourself a stream of interest income whose purchasing power will remain constant. This would be theoretically superior to cash, which would keep its nominal value but lose relative value, but also to regular bonds, whose interest rates would rise (assuming policy makers raised rates to control inflation) but whose principal would decline, as older bonds with lower coupon rates lost value. Dalio and others have pointed to TIPS as the best (only?) asset to guard against this scourge.

The TIPS series that will appear over the next few weeks is really a test of whether TIPS have, do and will perform as intended. In theory, theory and practice are the same; in practice, they are different, and so we’ll be doing some real world tests to see if they have a place in a Risk Parity portfolio.

Other Resources

If you’re still dying for more information about TIPS, this was the best deep dive into them I found, and notable for being a very pro-TIPS perspective (68 minutes long):

Here is another overview of TIPS for a general audience, with some discussion of their pros and cons (14 minutes long):