Not that the RP community has too many controversies, but if there is one, it might be on the proper role of Treasury Inflation-Protected Securities (TIPS). Announcing the start of a deep dive here at RPC, starting with a nice discussion of TIPS, inflation and expected returns from Steve Hou.
Regular readers might remember my summer series on REITs - eight posts looking at Real Estate Investment Trusts from several angles: academic research and professional whitepapers, backtests, asset comparisons and working through the pro and con arguments. I was trying to get at a big question: do REITs belong in a RP portfolio? In a few words, not really, as I summarize here:
Winter break and some time off from my day job gives me a bit of time to tackle the next big topic: Treasury Inflation-Protected Securities. For some RP proponents, TIPS are indispensable, a separate asset class worth a substantial allocation. For others, with voices equally as authoritative, they are just another type of fixed-income vehicle, undeserving of a dedicated allocation, much less a significant one.
To be clear, I have been on the latter half of this “debate” up to now. I own no TIPS in real life (though I have in the past). There are no TIPS allocations in any of the test portfolios, and in my blog posts so far, I have been pretty mum about TIPS, save for one post where I checked in on which assets were doing best amidst rising inflation. I have been targeting this time to take a step back and try to get a handle on them, so I'm now asking the same question of TIPS that I once asked of REITs:
The plan is write seven or eight posts to come over the next month or so. Some questions I’ll tackle along the way are:
- What are they? How do they work?
- Are they a separate asset class? How are they correlated with other assets?
- What do the experts say? I'll be looking for proponents and skeptics.
- Do they actually do what they promise? What do the backtests say?
- When do they work, and when not? I want to look specifically how they fare when inflation is high, such as in 2022.
- Are there alternatives? Are there other, simpler, or more efficient substitutes?
- And the most important of all - will they improve your RP portfolio?
As always, an interactive blog is a happy blog, so what questions about TIPS do you have? Do you have them in your portfolio - why or why not? Are there any assets that you’d like me to compare with TIPS? Let me know!
Setting the Stage
The uptick in attention to TIPS dovetails with the high inflation that has defined 2022. One big question to be answered is whether this is transitory and we'll soon return to the sub 3% norm of the 2010s, or if the recent experience mark a regime change where 3% is an absolute bottom and we get accustomed to higher rates over a long period of time.
I’m not the one to answer this, but following the edict that to “prepare, not predict,” I came across this resource (hat tip to both FV of Risk Parity Radio and AZ) addressing the question of how different assets do in periods of high inflation. It is from “The Market Huddle,” episode 201, where the hosts interview Steve Hou, a quantitative researcher from Bloomberg. In addition to the great interview in the first part of the video, Hou has made available this accompanying presentation for further study.
It’s a great interview, totally worth your time, but for my purposes, I wanted to highlight where Hou talks about TIPS, starting at the 1.18’55” mark:
A Bond By Any Other Name...
...would still be susceptible to duration risk. Essentially, TIPS are a combination of regular Treasury bonds whose value is subject to rising and falling interest rates, even more so the longer the duration of the bond, and then an inflation-matching overlay. The thing is, the duration risk typically overwhelms the inflation “bonus,” meaning that, even in periods of high inflation like now, there isn’t enough juice to overcome the squeeze on prices.
While TIPS are indeed a combination of two elements that determine their price, their duration is far more important, and so when interest rates are raised to fight inflation, this risk dominates. Hence, you’ve seen little benefit from holding TIPS lately, even though it would seem like just the time you’d want to.
In a nutshell, this has been a key element of the argument against TIPS in a portfolio: they just don’t actually do what they say they are going to. It’s in the name, after all, but they don’t seem to protect you from inflation any more than a folding umbrella would protect you from a hurricane.
Anyway, there is more to come. Is Hou right? Is there more to the story on TIPS? Stay tuned for more!