What…[should] investors [be] looking for to diversify their bond portfolio? We believe now may be a good time to consider Treasury Inflation Protected Securities (TIPS). Simply put, these securities offer protection against inflation. They pay interest twice a year, at a fixed rate, and they increase in value when inflation is on the rise, and decrease when inflation retreats.
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As the country’s central bank, the Federal Reserve (Fed) is charged with two overriding tasks: maximizing employment and stabilizing prices. By most accounts, the Fed has achieved its mission on the jobs front – but the same cannot be said for inflation, which has been running lighter than the 2% or so rate the Fed would prefer. Upcoming data will take on heightened importance both for the Fed debate over policy, and also for market expectations.
Prospects for rising inflation come on the heels of the easing of downward pressure on goods inflation.
- A stable dollar and stable or even rising commodity prices all point to upside potential in inflation figures in the coming months.
- the long-awaited signs of wage inflation have shown up, even if wage gains still pale in comparison to prior recoveries.
- Average hourly earnings in September grew slightly below expectations, but the year-over year figure, at 2.6%, continues to highlight the recovery in wages…
- Alternative measures that hold the mix of job holders constant (the Atlanta Fed Wage Tracker) show wages growing above 3%.
- Add to that survey data from small businesses, which continue to highlight the lack of qualified applicants and a rising share of firms raising compensation.
What does this all mean for investors looking for diversification within their bond portfolio? We believe now may be a good time to consider Treasury Inflation Protected Securities (TIPS). Simply put, these securities offer protection against inflation. They pay interest twice a year, at a fixed rate, and they increase in value when inflation is on the rise, and decrease when inflation retreats.
The impact of oil
As the chart below shows, the relative performance of TIPS vs. nominal Treasuries—(the “breakeven” rate noted in the chart refers to the difference between the yield on a nominal fixed-rate bond and the real yield on TIPS)—has been highly correlated to oil prices.
Part of the explanation for this is that TIPS are indexed to the headline U.S. consumer price index (CPI), and energy prices play a key role in that reading so recent headlines suggesting the possibility of an OPEC agreement to curtail supply have helped to lift oil prices, in turn boosting expectations for CPI. More broadly, the recovery in oil prices off the earlier year lows reflects a balancing of supply and demand, and that appears to lessen the risks of large declines in oil prices—a key downside risk to the relative performance of TIPS.
Substituting nominal Treasury exposure for TIPS exposure can potentially lead to a relative performance gain but the absolute short-term price performance of TIPS reflects mainly the outlook for real—or inflation-adjusted—rates. With the Fed poised to raise rates in December, real rates will likely increase. However, with rising inflation and the potential for rising inflation expectations, we expect TIPS should outperform nominal alternatives in such an environment.
Given that, we see attractiveness in using TIPS as an alternative for core Treasury allocations in fixed income portfolios.
Original Source: An unedited/unabridged version of the above post originally appeared on the BlackRock Blog.
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