Short-Term TIPS: The "Real" Risk-Free Asset

What are TIPS?

Treasury Inflation-Protected Securities (TIPS) are indexed to inflation (the CPI Index) in order to protect investors from a decline in the purchasing power of their investment. The par value of TIPS bonds changes to reflect changes in inflation after the date of issuance. Since the coupon (interest) payment is based on par value, that will also change. (Coupon payments occur every six months.)  Although the par value may fluctuate up (with inflation) or down (with deflation, a very rare occurrence), at maturity investors are guaranteed redemption at the original par value or adjusted par value, whichever is greater.

TIPS’ Nominal Yields 

Since 2010, many TIPS bonds have traded at prices that imply a negative nominal yield-to-maturity. The first instance of this happening was on October 25, 2010, when the Treasury sold TIPS with a 4.5 year maturity and a .5% coupon rate at an auction price of $105.51. Thus, at issuance, the yield-to-maturity of the bonds was -.55%, since at maturity they would be redeemed at par, or $100. (Following the convention for all bonds, TIPS bonds are quoted based on a $100 par value even though actual par value is $1000.)  

TIPS are issued with maturities of 5, 10, and 30 years. At present (May 19, 2022), according to Bloomberg, only the five-year TIPS bond is trading at a negative nominal yield-to-maturity:

Taxation of TIPS

Both nominal Treasury bonds and TIPS bonds generate income that is taxed by the federal government, but exempt from taxation by state and local governments. However, the taxation for TIPS bonds is a bit different than for nominal Treasury bonds. For both types of Treasury bond, the coupon payment is considered taxable income. However, in the case of TIPS bonds, the par value of the bond is adjusted based on changes in the Consumer Price Index for All Urban Consumers (commonly known as the CPI). To the extent that the par value of the TIPS bond is increased because of inflation, the increase in par value is considered taxable income even though no cash was received.

For example, assume a TIPS bond has an initial coupon rate of 1%, and is priced at $1000 (par). If the CPI rises by 2%, the inflation-adjusted par value of the TIPS bond will be adjusted up by 2% to $1020. The coupon rate will remain 1%, but because it is based on the inflation-adjusted par value, the coupon payment will be adjusted up from $10 to $10.20. All $10.20 is subject to federal income tax (but not state or local income tax). In addition, the $20 increase the bond’s par value is also subject to federal income tax (but not state or local income tax), even though no cash was received.

TIPS’ Interest Rate Risks

In the title of this article, I identified TIPS as the “real” risk-free asset. It is true that over a given investment horizon or holding period (such as one year), TIPS provide the potential of avoiding risk of any kind, including loss of purchasing power. Nominal Treasury bonds do not have that feature.

Since TIPS are Treasury securities, they are generally assumed to carry no credit risk. On the other hand, longer-maturity TIPS have much the same interest rate risk as regular Treasurys. In fact, because of their extremely low coupon rates, TIPS at the same maturity tend to have higher levels of interest rate risk, as measured by modified duration, shown in the graph below:

Particularly for long-term maturities, such as with the 30-year, the effect is quite dramatic. The modified duration of the 30-year Treasury bond is 20.3, which means that a 1% increase in interest rates would cause a 20.3% decline in price. Ouch! We have seen that play out thus far in 2022! The modified duration of the 30-year TIPS bond is even higher:  28.7! That means that a 1% parallel upward shift in rates would cause a price drop of 28.7%! Yikes! 

TIPS Yields

As shown in the graph below, the nominal yields for TIPS bonds are less than those of Treasury bonds of the same maturity. Considerably less. The difference reflects the market consensus regarding the changes in CPI during the holding period of the bond.

For example, the difference between the 2.10% yield of the one-year Treasury bond and the -2.87% yield of the one-year TIPS bond is 4.97%. If the actual change in the CPI during the one-year holding period turns out to be 4.97%, an investor would be indifferent between holding the Treasury or the TIPS, excluding other considerations, such as differences in liquidity (Treasury bonds are much more liquid) and taxation (Treasury bonds are taxed only on cash received in coupon payments and capital appreciation or depreciation of principal at maturity, whereas TIPS bonds are taxed not only on cash coupon payments but also on CPI-related adjustments to par value even before maturity).

The spread between Treasury yields and TIPS yields shrinks noticeably for bonds of longer maturities. The spread for 5-year maturities is only 2.98%, for 10-year, 2.60%, and for 30-year, 2.43%. Clearly, the consensus of bond investors is that inflation is likely to greatly moderate in the years ahead.

The graph below provides a longer-term perspective on the changes in inflationary expectations as reflected in the Treasury-TIPS yield spread. In the wake of the Great Recession of 2008, there was a widespread fear of deflation, and the spread plunged into negative territory. That quickly evaporated as the Fed aggressively cut interest rates to zero and added “quantitative easing” (massive purchases of Treasury and mortgage-backed bonds) to further prime the economic pump.

Inflationary expectations came down again in the wake of the Covid-induced recession of 2020, but again, aggressive Fed policy quickly reversed inflationary expectations, and they have been on an upward trend ever since.

Inflation Forecasts

Treasury-TIPS yield spreads provide one measurement of inflationary expectations. One of the strengths of this method of gauging expectations is that it is market based, meaning that there is actual money being invested by a wide group of market participants. On the other hand, there are certain structural differences between Treasury bonds and TIPS bonds (liquidity and taxation) that introduce some time-varying influence (“statistical noise”) on the spreads. For example, when the market is nervous and in “risk-off” mode, the illiquidity of TIPS bonds is likely to drive down their prices and drive up their yields, reducing the Treasury-TIPS yield spread and the implied inflation forecast.

The other major methodology for gauging inflationary expectations is with surveys. There are several organizations that provide inflation forecasts through surveys of consumers, economists, and market strategists. My subscription to FactSet gives me access to CPI forecasts provided by participating brokers, who often have economists and market strategists on staff. The average of these forecasts provides another consensus estimate of future inflation.

The graph below shows actual 12M forward Y/Y CPI change (in green) compared to the two forecasting sources, broker CPI forecasts (in blue) and 1Y Treasury-TIPS yield spread (in orange). It is a visual way of trying to answer the question, “just how good have these two forecasting methods been in the past?”   

The broker forecast time series is much longer. The striking thing about it is that it is almost always on top of what the actual CPI change was over the preceding 12 months. That is, the broker forecasts look like they pretty much just extrapolate recent inflation experience.

Comparing the two forecast sources to each other, it appears that the broker forecasts (blue line) were consistently above the Treasury-TIPS spread (orange line) until last October, when the Treasury-TIPS spread jumped to 3.54% and the broker CPI forecast was 3.30%--moving up, but more slowly. Since that time, they have both been moving up quickly, seemingly chasing the same signal from actual Y/Y CPI change, which seems to have perhaps peaked at the end of April at 8.65%. (Time will tell if that was actually the peak.)    

Clearly, neither the broker forecasts nor the Treasury-TIPS spread anticipated the dramatic jump in inflation that has taken place over the last 12 months.

Forecasting inflation over the next 12 months should be far easier than forecasting inflation over a longer horizon, such as five years. Even so, it would appear that neither broker forecasts nor Treasury-TIPS yield spreads have been particularly accurate. A full overlapping data set is available for both back to April 2014 (8 years), and as one measure of accuracy, here are the correlations between forecasts and actual:

The best one-year forward forecasts are from the market-based Treasury-TIPS yield spread. Broker forecasts are less prescient than even simply using the trailing CPI change for the previous 12 months!

Broker forecasts are available not just for the next year, but also two years out and three years out. This data is shown in the graph below. The 12-month forecast of 5.18% appears to be heavily influenced by recent CPI changes, but further out, the forecasts are for Y/Y CPI to slow down to between 2% and 3%.  We noted above that the 5-year Treasury-TIPS yield spread is 2.98%, so it would appear that both the broker forecasters and TIPS bond investors expect inflation to slow down quite a bit over the next few years.    

Forecasting TIPS Total Returns  

For investors, the most important consideration for an investment is its expected return. For TIPS bonds, the expected return is comprised of two parts:

                    Nominal yield-to-maturity

                + Expected CPI change

                = Total TIPS expected return

If the prices of TIPS bonds accurately forecast future CPI changes, then the best total return forecast for TIPS of a given maturity would be the yield-to-maturity on Treasury bonds of the same maturity.

The one-year broker average forecast for CPI of 5.18% is just a bit higher than the one-year Treasury-TIPS yield spread of 4.97%, though it is quite close. The further out forecasts from both sources are lower, as shown in the following table:

The One-Year TIPS Bond

How reasonable are the two one-year forecasts of CPI change, the broker forecast of 5.18% and the Treasury-TIPS spread implied forecast of 4.97%? The most recent month/month changes in CPI have actually been increasing, not decreasing (as of May 19, 2022):

While it may be possible that future CPI changes will plummet over the next year enough to line up with the broker forecast of 5.18% and the Treasury-TIPS yield spread of 4.97%, that does not seem likely to me, as an experienced time-series analyst. So, I believe that the one-year TIPS bond is a buy.    

The Five-Year TIPS Bond

Regarding the five-year TIPS,  the broker forecasts are even more optimistic about future inflation than the bond market, at least for years 2-5. Remember, to break even relative to the Treasury bond, the CPI rate of change for the next five years must average at least a rate of 2.98% per year. If we assume for the moment that the Broker forecasts for years 2 and 3 are accurate, what would the CPI increase in years 4 and 5 have to equal in order to make the five-year TIPS bond break even with the five-year Treasury bond?  The answer is an average of 2.1% for years 4 and 5.

Again, as an experienced time-series analyst, that seems like an aggressively low expectation for inflation. Therefore, I believe that the five-year TIPS bond is also a buy.

The Ten-Year TIPS Bond

How about the ten-year TIPS bond? Recall that the Treasury-TIPS yield spread for the 10-year is 2.60%. If we again assume that the broker forecasts for years 1-3 are completely accurate, the average for years 4-10 would have to be about 2.27%. Not quite as aggressively low as 2.1%, but close. This makes the ten-year TIPS bond perhaps not quite as compelling a buy as the five-year TIPS bond, but close. However, trying to forecast inflation that far into the future seems to me a fool’s errand. And given the higher duration (interest rate risk) of the ten-year TIPS bond, I am less than enthusiastic about buying it.

TIPS ETFs

Most investors, including me, do not buy individual bonds. We buy bond funds. I generally prefer to use low-cost ETFs to gain exposure to bond segments, including TIPS. Among the TIPS ETFs available, there are four that stand out for their low expense ratios and razor-thin bid-ask % spreads, listed in the table below:

As the discussion above may have hinted at, it is not a simple matter to establish the expected return or yield of TIPS bonds or TIPS funds. The most straightforward yield figure in the table above, the “Fund Distribution Yield, ” measures the amount of dividend distributions over the past 12 months divided by the current price. That is, it is entirely backward-looking, and is not terribly relevant for forecasting expected future yield and return, since the CPI changes of the previous 12 months are not likely to be repeated over the next 12 months. The “Fund Weighted Average Yield-to-Maturity” figures in the table  were downloaded from the fund websites. IShares updates its website daily, but Vanguard and Schwab update only monthly, so the figures really aren’t comparable among each other, and how they are derived is not described.

Since these ETFs are passively managed relative to a benchmark, I believe that the yield and duration statistics for the benchmarks are probably the most accurate, reliable, and comparable indicators of return and risk. Both of the short-term TIPS funds are benchmarked to the same index: Bloomberg US Treasury TIPS (0-5 Year) Index. Both of the intermediate-term TIPS funds are benchmarked to the same index:  Bloomberg US Treasury Inflation Protected Securities (TIPS) Index.

The nature of TIPS bonds makes it very difficult to estimate yield and duration, even for Bloomberg. The Bloomberg website’s “Fixed Income Index Methodology” document indicates that for TIPS, Bloomberg uses an “Empirical Duration” based on returns over a trailing 60-day period. I did not find an explicit discussion of yield for TIPS indexes, but in a few places it seemed to suggest that they were based on a “breakeven” calculation, which I believe would mean that they use the nominal yields of Treasury bonds matched to individual TIPS bonds using a maturity, coupon, duration, and convexity matrix.

The portfolios of the two short-term TIPS funds and the two intermediate-term TIPS funds should be virtually identical nearly all of the time. Therefore, only the differences in expense ratio and bid-ask % spread would separate them. Based on these two criteria, I have a very slight preference for STIP over VTIP, and more of a preference for SCHP over TIP, since SCHP has a materially lower expense ratio.

Many investors gravitate towards broad bond funds on the assumption that it is best to invest in the entire bond market, and the broadest segments thereof. I do not subscribe to this philosophy. Investing in a broad bond index lets the issuers structure your portfolio for you. I believe that issuers of bonds act in their own interests, not the interests of bondholders.

Instead, I believe that investors should weigh the risks and yields of various types of bonds against each other. In the case of TIPS ETFs, it seems obvious that the incremental yield of intermediate-term TIPS funds over short-term TIPS funds is very slim, but the additional interest rate risk (as measured by duration) is enormous. Consequently, I believe that short-term TIPS funds should be preferred over intermediate-term TIPS funds.

Within the short-term TIPS category, I have a very slight preference for STIP over VTIP based in its slightly lower expense ratio and bid-ask % spread.

Summary and Conclusions

• Treasury Inflation-Protected Securities (TIPS) offer a return indexed to the CPI.
• Longer-term TIPS have somewhat higher levels of interest rate risk (duration) compared to Treasury bonds of the same maturity.
• Nominal yields for TIPS are much lower than for Treasury bonds of the same maturity, and may even be negative.
• The Treasury-TIPS yield spread provides a market-based forecast of inflation.
• Surveys also provide inflation forecasts, including the broker survey data provided by FactSet.
• Both the broker forecasts and the Treasury-TIPS yield spreads are indicating that year/year CPI, which was 8.18% in April 2022, is expected to decline in the coming months and years.
• The question for TIPS investors is whether the Treasury-TIPS yield spread implied inflation forecast is too low (buy the TIPS) or too high (avoid the TIPS).
• I believe that both the one-year and the five-year TIPS bonds are a buy.
• The ten-year TIPS bond is only slightly less attractive from an expected return standpoint, but the interest rate risk (duration) is so high that I would avoid any TIPS with maturities over five years.
• Both short-term TIPS ETFs (STIP and VTIP) are benchmarked to the Bloomberg US Treasury TIPS (0-5 Year) Index.
• The expense ratio and the bid-ask spread % for STIP are just a hair below those for VTIP, so I recommend that fund first and foremost.