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History shows that rising inflation, if left unchecked, erodes investment growth. It’s no surprise, then, that the prospect of watching inflation decimate the value of a healthy portfolio balance often motivates investors to look for a potential hedge.

Treasury Inflation-Protected Securities, also known as TIPS, can offer a fixed-income allocation strategy that potentially checks a number of boxes for the risk-aware investor: they can offer built-in protection designed to keep up with rising prices; they can help diversify equity-heavy portfolios, and they come with an added bonus—the backing of Uncle Sam.

How TIPS Work

TIPS are government-issued US bonds that are structured with one purpose in mind: inflation protection (it’s right there in the name). Because their principal value is indexed to the Consumer Price Index (CPI),1 the face amount of a TIPS bond can adjust upward or downward every six months to match the CPI. Though TIPS can adjust their principal, their interest rate remains fixed. Interest is calculated twice a year off the CPI-adjusted principal and paid twice a year. Interest payments, therefore, rise or fall after the adjusted principal is multiplied by the fixed coupon rate (see FIGURE 1). 

If held to maturity, bondholders are repaid either the adjusted principal amount or the original amount, whichever is greater; this protects investors from a less likely risk: deflation (a general decline in prices for goods and services).

FIGURE 1

How TIPS Work
Semiannual Interest Payments Are Tied to the CPI

Year Coupon Inflation Principal Interest Paid
1 3% 0% $1,000 $30.00
2 3% 6% $1,060 $31.80
3 3% -2% $1,038.80 $31.16
4 3% -5% $986.86 $29.61
5 3% 10% $1,085.55 $32.57

Past performance does not guarantee future results. For illustrative purposes only. Sources: Federal Reserve and Hartford Funds.

In the hypothetical example above, a holder of a 5-year TIPS would earn $155.14 at maturity, compared to $150 earned if the face amount had remained fixed at par. An investor could come out slightly ahead despite having experienced a 2% and 5% fall in prices in years 3 and 4. 

TIPS never return less than the original principal if held to maturity.

Because TIPS never return less than the original principal—if held to maturity—investors who buy them when issued and hold them to term can expect a positive real return. Investors could also sell their TIPS ahead of maturity, but they risk doing so at a loss if inflation slows down. For example, if forced to sell in year 4 of the example in FIGURE 1, investors could see their investment dip below the original face value.

TIPS are offered in maturities of five, 10, or 30 years, and can be purchased as individual bonds from TreasuryDirect.gov. TIPS are not the same as Series I savings bonds (commonly referred to as I-bonds), another type of inflation-protected US Treasury security that sometimes pays better rates but features a fixed principal and is subject to strict purchase limitations.2 

If safety ranks equally in importance with inflation protection, investors may find a measure of comfort in knowing that TIPS enjoy the backing of the full faith and credit of the US government, which guarantees principal payment for its bonds at maturity—except in the unlikely event of a US default on its debts.

But TIPS owners could pay a price for the built-in inflation protection they receive, particularly if inflation were to stage a slowdown. The return on TIPS are typically lower than that of standard fixed-rate US Treasuries. Actual inflation would have to exceed standard Treasury rates to compensate for the difference in yields.

 

Real Yields vs. Nominal Yields

It’s probably less than helpful to focus too closely on the question of TIPS yields because in some ways it’s like comparing apples to oranges. Yields on a normal fixed-rate Treasury bond are considered nominal, i.e., the coupon rate, whereas yields on TIPS are dubbed the real rate, i.e., what an investor would earn after inflation is factored in.

To determine TIPS yields, the breakeven inflation rate must first be calculated—a handy term for discerning whether a traditional fixed-income investment breaks even with inflation. To find the breakeven inflation rate, subtract the expected inflation rate from the nominal rate of a benchmark security, such as a 10-year US Treasury.

Today, a nominal fixed-rate Treasury bond isn’t likely to offer much inflation protection in a rising-rate environment, and nominal yields are already below average as a result of the persistently low interest-rate environment of the past decade. So subtracting a high expected inflation rate from a low nominal yield means TIPS yields end up negative.

For example, as of January 7, 2022, the breakeven rate stood at 2.48%. When you subtract the  breakeven rate from the 10-year Treasury yield of 1.76% (as of January 7, 2022), you get -0.72%, the current 10-year TIPS yield.3 

So why buy TIPS? In effect, TIPS holders are sacrificing yield for the anticipated reward of protection against rising inflation in the long run (i.e., higher earned interest and principal growth). If actual inflation runs higher than 2.48% per year over the life of the bond, investors would be compensated by the stream of principal increases and higher net interest payments over time. If inflation only reaches the breakeven rate, a TIPS investment would be at least comparable to investing in a standard fixed-rate 10-year US Treasury bond (see FIGURE 2). 

FIGURE 2

Actual Inflation > 2.48%? TIPS Could Be the Better Bet
Average 2021 Year-Over-Year Inflation Exceeded the Year-End Breakeven Rate (%)

Quoted yields as of 1/7/22. Sources: Treasury.gov, US Bureau of Labor Statistics, and Hartford Funds.

Interestingly, by averaging each of the 12 monthly annualized inflation rates reported by the US Bureau of Labor Statistics for 2021, the actual year-over-year inflation rate turned out to be 4.68%.4 The gap between the breakeven rate and the higher year-over-year average rate could be viewed by investors as a signal to at least consider a TIPS allocation going forward.

Bottom line: Investors could accept today’s negative yield if they think the CPI will continue ratcheting up the principal and interest payments of their TIPS holdings. 

 

If interest rates rise, a skilled professional manager can swap lower-yielding TIPS for higher-yielding bonds to help boost total return.

Hartford Inflation Plus Fund: Professionally Managed Inflation Protection

For investors with concerns about how potential tax liability could impact their ownership of individual TIPS, the Hartford Inflation Plus Fund (HIPIX) offers a professionally managed pool of fixed-income securities with the aim of providing a total return that exceeds the rate of inflation over an economic cycle.

 The Fund invests at least 65% of its holdings in TIPS. The remaining 35% can be allocated tactically to a variety of other sectors, including, but not limited to, nominal (non-inflation-protected) US fixed-income securities, currencies, corporate bonds, asset-backed securities, mortgage-related securities, and commercial mortgage-backed securities. 

 

TIPS Bonds vs. Bond Funds or ETFs

The idea of built-in inflation protection sounds appealing. But an obvious drawback to owning individual TIPS is that inflation could actually subside ahead of the bonds’ maturity date, and an investor would have locked in a negative yield. Interest rates also could rise while TIPS investors are stuck with those low or negative yields. And even if inflation rises above the breakeven rate, TIPS investors could wind up having to pay federal capital-gains taxes (but not state or local taxes) on both the earned interest and the unrealized principal gains. 

That’s why some investors prefer to participate in TIPS through professionally managed mutual funds or by buying ETFs whose holdings emphasize TIPS (see sidebar on the Hartford Inflation Plus Fund). Like other fixed-income mutual funds, TIPS funds can also generate capital gains, but investors benefit by having the CPI-driven adjusted principal distributed monthly throughout the year instead of having to wait until maturity. So, while you still pay federal taxes, you’re earning the income on which those taxes must be paid.5 Experts say it’s best to consider holding a TIPS-themed fund or ETF within a tax-deferred account.

Active management can also provide advantages for fund investors. If interest rates rise over the next few years as expected, a skilled professional manager can swap lower-yielding TIPS for higher-yielding issues to help boost total return.

There are other trade-offs to consider. If interest rates rise, they could bring downward price pressures to longer-maturity, duration-sensitive6 TIPS held within funds or ETFs, even as inflation is pushing up the principal value at the same time.

 That said, there’s considerable evidence that TIPS can provide needed ballast to portfolios that are overly weighted to equities. Throughout the last 26 years, TIPS have exhibited very low correlations to equity markets (FIGURE 3). Additionally, during previous bear markets, TIPS have historically helped limit downside exposure while providing diversification benefits (FIGURE 4).

FIGURE 3

TIPS Correlation7 to Equity Markets
(1/1/06-9/30/21)

S&P 500 Index used to represent US equities; MSCI EAFE Index used to represent international developed equities; MSCI Emerging Markets Index used to represent emerging-market equities; Bloomberg US TIPS Index used to represent TIPS for correlation comparison.Full index definitions shown below. Source: Morningstar.

FIGURE 4

TIPS Have Historically Helped Limit Downside Exposure in Equity Bear Markets
Cumulative Returns of Equities and TIPS During the Three Most Recent Bear Markets (%)

Past performance does not guarantee future results. Investors cannot directly invest in indices. Date range for tech-bubble data: 3/24/20 to 10/9/02. Date range for Global Financial Crisis data: 10/9/07 to 3/9/09. Date range for COVID-19 equity-crash data: 2/19/20 to 3/23/20. Sources: Morningstar Direct and Hartford Funds.

Conclusion

As the US economy has emerged from the worst ravages of the COVID-19 pandemic, rising wage pressures and the upward march of consumer and commodity prices have introduced investors to the unfamiliar taste of inflation, a problem not seen since the 1970s. Investors who are concerned that inflation will be higher than it has been in the recent past should consider the benefits of allocating to TIPS. 

To learn more about inflation-linked fixed-income securities, talk to your financial professional.

 

1 The CPI in the United States is defined by the Bureau of Labor Statistics as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

2 I-bond investors are subject to a purchase limit of $10,000 each calendar year for electronic purchases via the TreasuryDirect.gov web site. Paper purchases are subject to a $5,000-per-year purchase limit. TreasuryDirect.gov.

3 Daily Treasury Real Yield Curve Rates, Treasury.gov, 1/7/22.

4 Bureau of Labor Statistics. Average of each reported 12-month annualized percent change in the CPI for 2021.

5 Understanding Treasury Inflation-Protected Securities (TIPS), PIMCO, 10/11/21.

6 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

7 Correlation is a statistical measure of how two investments move in relation to each other. A correlation of 1.0 indicates the investments have historically moved in the same direction; a correlation of -1.0 means the investments have historically moved in opposite directions; a correlation of 0 indicates no historical relationship in the movement of the investments.

 

Index Definitions:

- S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.

- MSCI EAFE Index is a free float-adjusted capitalization index that is designed to measure developed market equity performance, and excludes the US and Canada.

- MSCI Emerging Markets Index is a free float-adjusted market capitalization-weighted index that is designed to measure equity market performance in the global emerging markets. MSCI index performance is shown net of dividend withholding tax.

- Bloomberg US TIPS Index consists of Treasury inflation-protected securities issued by the US Treasury with a remaining maturity of one year or more.

 

“Bloomberg®” and any Bloomberg Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Hartford Funds. Bloomberg is not affiliated with Hartford Funds, and Bloomberg does not approve, endorse, review, or recommend any Hartford Funds product. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to Hartford Fund products.

Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

Important Risks: Investing involves risk, including the possible loss of principal. Security prices fluctuate in value depending on general market and economic conditions and the prospects of individual companies. The Fund may allocate a portion of its assets to specialist portfolio managers, which may not work as intended. • Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • The value of inflation-protected securities (IPS) generally fluctuates with changes in real interest rates, and the market for IPS may be less developed or liquid, and more volatile, than other securities markets. • Obligations of US Government agencies are supported by varying degrees of credit but are generally not backed by the full faith and credit of the US Government. • Derivatives are generally more volatile and sensitive to changes in market or economic conditions than other securities; their risks include currency, leverage, liquidity, index, pricing, regulatory, and counterparty risk. • Mortgage-related and asset-backed securities’ risks include credit, interest-rate, prepayment, and extension risk. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic, and regulatory developments. • The purchase of securities in the To-Be-Announced (TBA) market can result in higher portfolio turnover and related expenses as well as price and counterparty risk. • The Fund may have high portfolio turnover, which could increase its transaction costs and an investor’s tax liability.

Diversification does not ensure a profit or protect against a loss in declining market.

The views expressed here should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams, and different fund sub-advisers, may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds. 

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