TIPS During Inflationary Stretches: Do They Deliver?

In the last post, I took the widest view of TIPS performance I could. This time, I assume I possess perfect timing to look at how TIPS fared during four stretches of high inflation over the past two decades. When its number is called, does this inflation-protection device actually protect?

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This is the sixth post in my "RPC Investigates" series on Treasury Inflation-Protected Securities (TIPS). The first post introduced them and what I'm trying to do in this deep dive; the second was a Risk Parity Basics post explaining them from the ground up; the third differentiated between TIPS purchased individually and TIPS in funds. The fourth assembled five sources for more learning on TIPS. The most recent post presented results from two backtests (21 years and 13 years) of TIPS.

For this post, you may also want to familiarize yourself with a post I did back in April 2022.

I looked at how inflation-proof certain asset classes: two types of equities (large-cap and small-cap value), commodities, gold, REITs, and of course, TIPS, really were over what had then been 12 months of elevated inflation. The take home point was that commodities were the place to be and TIPS decidedly had not done their job in the least.

In this post, I’ll reopen that line of inquiry, and look at how TIPS have performed in other periods of higher inflation (in a relative sense). The inflation of 2021 and 2022 has been idiosyncratic (invasion of Ukraine, rebound from pandemic, previous stimulus checks, etc.), as all particular periods are, so a wider look at a variety of inflationary periods will help. If, with perfect foresight, you could have foreseen upcoming inflation, would TIPS have been the best way to prepare your portfolio?

Before the Backtests…

A couple of ground rules first.

We are going to assume perfect foresight about inflation, starting our backtests just before inflation ramps up. If I identify inflation beginning in March, for example, I’ll start the backtest in February in order to catch low prices before the market is aware of higher inflation.
When it comes to ending the backtest, I’ll go one month past the end of the inflation in order to catch any lag, but also not lose out on too many of the gains that should have accrued while inflation is high. For example, if August is the last month of inflation, I’ll put September in as the end of the back test in order to capture that month’s returns. Of course, there is an exception for the current inflationary period which doesn't yet have an ending point.
I’d love to do the 1970s, but TIPS weren’t invented until 1997. Meanwhile, I don’t have easy to use data before 2001, so I’m a little limited. By the way, I’m on the lookout for a reconstructed list of what TIPS would have done during this time - the closest I have found is the work by Edward Qian which is summarized in this post (point #4, towards the bottom).
If the period of inflation happened between ‘01 and ‘09, I’ll use the comparison asset classes I used in the first backtest from my last post, but I’ll add in commodities if I can. If the period is October ‘09 or later, I’ll use the exact comparison asset classes and specific funds from my second backtest.
Since some of the periods are less than one year but others are for more, I entered in “no rebalancing” for all tests to keep things even.
The most important statistic about any portfolio for me is the perpetual withdrawal rate, but here I’m not reporting them, since the time periods are so short as to make the number nonsensical. If interested, follow the links and go to the “metrics” page.

With these guidelines in mind, I identified four periods of “higher” inflation since 2001. I used data from the US Inflation Calculator which in turn is based on CPI data from the Bureau of Labor Statistics. You’ll see the inflation numbers for the period at the start of each backtest.

Backtest #1: May 2004 through August 2006

Not really severe inflation at all, but it did stay above 3% for quite a while and hit 4% six times, with just a few sprinkled months below 3%. Despite not being that dramatic, it is a good test since the mild inflation of this time contrasts with the current experience.

Here are the results for backtest #1:

Pretty much a tie, and given there were two and a half years of data in the backtest, it is not so short that a great asset wouldn’t have had the time to separate itself. Slight CAGR boost with the TIPS fund, but a little more volatility, too, all ending in a practical dead heat when it comes to the important Sharpe ratio.

Backtest #2: October 2007 through October 2008

This was the ramping up first half of the Global Financial Crisis before the huge economic declines brought inflation down so quickly that we actually went into deflation for most of 2009. It’s funny, I didn’t remember the inflation in the first part of the crisis at all, since the real news was the bottom falling out toward the end of 2008.

Here are the results for backtest #2. For this time period, we’re lucky to be able to add commodities to the mix, but since you can only test three portfolios at a time, the link for the commodities test is here.

Not great for TIPS. Here you have the high inflation that TIPS are designed for, but they lost out substantially to nominal Treasuries and were more volatile, as well. They did look pretty good compared to commodities, though.

There was an interesting pattern to the returns. All portfolios were doing well up until July 2008 or so, and the higher inflation wasn’t acting as a drag until then. Declines started off as a jog in the late summer and early full before turning into a full sprint with October 2008’s big crash.

All four of these Golden Butterfly versions mostly survived the frying pan of inflation…it was the fiery crash that got them. The portfolio with TIPS was (just barely) beating the other portfolios with Treasuries as of August 31, 2008, but then fell behind those two over the next two months. Commodities, meanwhile, were far in the lead as of June 30th, but then fell even lower than TIPS by Halloween. I thought about separating out the periods, but then again, the crash is part of the story, too.

Could the lesson be that TIPS, or commodities for that matter, are fine as long as you can accurately predict when exactly the crash will happen and then get out just before? That's a stretch, for sure.

Backtest #3: April 2011 to February 2012

This period wasn’t even that big of a deal, but still qualifies as the fourth worst stretch of inflation in the past 21 years. I was investing by this time, but honestly, had no idea about this inflationary event until I saw it on the chart. It was probably barely noticeable even at the time. The bigger story was that markets were recovering from the GFC and just about everything you invested in did well. I did think about excluding this period, but wanted to check out how TIPS fared in the mundane world of just an ever so slight rise in prices.

Here are the results, with two separate tests (using the same parameters) since you can only test three portfolios at once. Backtest #3a: 1) TIP, 2) STPZ, 3) LTPZ; Backtest #3b: 1) SHY, 2) UUP, 3) DBC.

Six possible portfolios for inflation and those with TIPS finished first, second and third in terms of CAGR – a very good set of results for sure. Short-term Treasuries and the Bullish Dollar fund were a bit more stable, but superior returns for TIPS meant high Sharpe ratios after all was said and done. The effects were most pronounced with the Long-term TIPS, and that 426 basis point improvement over the original Golden Butterfly portfolio with Short-term Treasuries is significant.

On the shorter side of the duration scale, it is worth noting that the nominal and the TIPS versions did about the same. I wonder if the real story is just that it was the duration of the bonds which was the key, not being a TIPS or not. Hmmm…

Of course I tested it! I ran a new backtest with three portfolios: the version with Long-term TIPS, one where there is just a 40% allocation to Long-term Treasuries, and then one with EDV, Vanguard’s Extended Duration fund. EDV is a favorite of mine, and make sure to read why in this write-up of why it is my preferred asset for long-term fixed income. Anyway, the results:

Boom! Now those are some results! Long-term TIPS were great, but it’s because of the first part of their definition, not the second.

Backtest #4: April 2021 to present

Well, you know about this for sure, as it has been topic 1A for more than a year.

Here are the results: Backtest #4a: 1) TIP, 2) STPZ, and 3) LTPZ; Backtest #4b: 1) SHY, 2) UUP, and 3) DBC.

Eh, not great for TIPS, and conforms to what I found back in April. For whatever reason, this brand of inflation hasn’t been the right environment for TIPS to do well in. Of the six, the TIPS portfolios had disappointing CAGR numbers, relatively high volatility, and bad Sharpe ratios.

With a name like “inflation-protected,” you’d love to see performance like with UUP or PDBC, and to be even just marginally positive given the circumstances. As mentioned before, commodities have their own logic, and the rise in PDBC over the past year and a half is better stated as a cause of inflation, not as a reaction. The dollar meanwhile, has been a good place to be, but even the portfolio with UUP has still lost ground in real terms. Of course, TIPS have done that one better - they have lost ground in nominal terms, as well.

Conclusions

What’s Tolstoy’s quote, that all happy families are alike but the miserable ones are miserable in their own way?

That is sort of how I am now thinking of inflation and what assets do well while it's happening - that we’d need to be a whole lot more specific about what type of inflation it is and then analyze the links with asset classes.

They are certainly quite different. The 2008 one is the first half of a major economic crisis. The current one has been accompanied by a decline, but not all that major considering (yet?), and one defined by the recovery of commodities after 15 years of nothingness and the strongest dollar in two decades. The 2004-06 one was mild inflation in the midst of pretty average market returns, while the 2011 one was modest inflation in the middle of a huge market upswing.

If someone were trying to promote TIPS, I’m sure the argument could be made that the 2004 inflation was really a “X-type,” not great for TIPS, and then the 2021 burst is a “Y-type” and so on and so on, explaining why TIPS would have worked if only the Fed responded differently, or Z hadn’t happened, or this or that. I don’t really understand the ins and outs, and will leave that to more sophisticated analysts to explain.

At the same time, from the perspective of a modestly knowledgeable but still amateur retail investor, that might be paralysis by analysis. At the most basic level, an asset class promising inflation protection should, well, protect you from inflation, whether it is type X, type Y, or whatever. If there are too many exceptions for when TIPS funds will work, then perhaps they are more trouble than they are worth. Mind you, I’m only speaking of TIPS in fund form and I acknowledge that stand-alone TIPS may actually be great in those circumstances.

All things considered, TIPS in fund form really weren’t much of a portfolio protector during inflation.

They did alright with #1, though not all that different than regular bonds, lost out to Treasuries in #2, did fine in #3 (but not because they were TIPS, per se) and then not fine at all in #4. To deserve the “inflation-protected” moniker, you’d like to see more consistency and especially avoid a situation like the last 18 months, when they actually hurt an already injured portfolio.

With those broad thoughts in mind, here are some specific things I noticed in the backtests:

The behavior of TIPS seemed a lot just like other bonds where duration was the crucial factor in their performance, not their special overlay for dealing with inflation. Backtest #3 was instructive in this regard. LTPZ had the best performance of the original six, but when I added in two other Long-term bond possibilities, it finished behind those.
Within the realm of TIPS, it seems like you’re better off with Long-term TIPS if you are prioritizing growth, and Short-term TIPS if you are looking for portfolio stability. Guess what? Just like regular Treasuries. Broad TIPS funds, meanwhile, seem to be a good compromise between the two.
If you remember the correlation matrix from the last post, you’ll recall that the correlation between TIPS and other assets was in positive territory when compared to both types of equities. We can see what impact that has on a portfolio with inflation periods 2, 3, and 4. In each of these, TIPS produced more of what was already going on with stocks: adding to the good times in #3 and then piling on to the declines in #2 and (especially) #4.
One idea I’ve had floating around is that commodities might be the inflation-protector one is actually looking for when TIPS are in the discussion. This does NOT seem to be the case based on these backtests, however, or rather, it seems that commodities have their own dynamic and even elevations in inflation aren’t enough to pull commodities out of their own market cycles. Commodities did terribly in #2 and also #3, but then became the best thing in #4. I’m still a fan of commodities, of course, but they have not been a consistent inflation fighter, either.
I’m intrigued by UUP and think I’ll dive into it in more detail in a future post. It doesn’t produce great returns, but #3 and #4 show its value as ballast. In both backtests, the portfolio with UUP had the lowest standard deviation and the second-best Sharpe ratio. In a Golden Butterfly portfolio, that fifth normally devoted to Short-term Treasuries is expected to be the portion that stabilizes and is not counted on for capital appreciation. UUP seems like it has potential in other contexts fulfilling this role.
Even with the benefit of 20/20 hindsight over 20 years and identifying the right conditions for them after the fact, I can’t find strong indications that they do what they promise. We may just be asking too much of TIPS in the sense that, when this “perfect” environment happens, we expect TIPS to pop and make up for the years and years when we expected nothing of them while inflation was low. TIPS may do ok during inflation, with some wins and some losses, but they certainly don’t have the outsized performance that would give you the funds to pour into other asset classes or allow you to comfortably draw them down for expenses while other asset classes recover.

Will holding them individually make more sense? I’ll try to figure that out in the next post.