Inflation Protection

Are TIPS a good inflation hedge?

I started my career designing hedging programmes for UK defined benefit pension plans which have exposure to both ...

April 1, 2021

I started my career designing hedging strategies for UK defined benefit pension plans which have exposure to both interest rates and inflation in their liabilities. Inflation-linked government bonds were often the instrument of choice to hedge the inflation-linked portion of the liabilities.

However when I started to work on broader areas of investment strategy, I met with multi-asset portfolio managers who told me that inflation-linked bonds were not a good inflation hedge.

This was puzzling to me and therefore an interesting topic to explore.

More recently, inflation protection has risen up the agenda for many investors and so has the topic of whether inflation-linked bonds are a good inflation hedge.

A paper from BlackRock outlines the benefits of including TIPS over nominal bonds to protect against a potential inflationary environment ahead.

Whereas a paper from AQR reveals analysis that TIPS have almost no inflation sensitivity. 

So what gives?

The answer is: it’s all about expectations

Firstly, what is the expectation of the investor buying the hedge?

The principal of TIPS is adjusted for inflation (as measured by the Consumer Price Index). In addition, the interest rate that TIPS pay is a fixed proportion of the inflation-adjusted principal. This means that both principal and interest payments rise with inflation and fall with deflation. 

If TIPS are held to maturity they are a real asset. Therefore, if you have a set investment time horizon (e.g. to match future pension payments), then you can attempt to align the term of the TIPS with that time horizon. This would meet your expectations for a good inflation hedge. 

However, it's different for investors that do not have an explicit time horizon or inflation-linked liabilities to meet. Their goal is likely to preserve the value of the portfolio in inflationary environments. 

These investors therefore care much more about how much the value of the TIPS increase over periods of high inflation. On a mark-to-market basis, the price of TIPS will change as real yields change.

There are therefore inflationary environments where TIPS do not perform well, for example, if nominal interest rates also rise and therefore real yields either stay the same or increase.

Now comes the other type of expectations that matter.

The mark-to-market value of inflation-linked bonds also depends on the market's expectation of future inflation. For long-dated inflation-linked bonds the value of the bonds is much more sensitive to changes in expectations than to changes in realized inflation.

This means that if we have short term inflation surprises but inflation expectations remain anchored, then the mark-to-market gain of TIPS could be muted. 

If the market continues to underestimate realized inflation, the pay-off would still accrue to investors that held TIPS to maturity (thus squaring the circle with the first type of investor). However you wouldn’t see the immediate gain in mark-to-market. The TIPS holder would have to be patient to realize the gain.

In recent history, central banks have done a good job of keeping inflation expectations well anchored. Therefore, back-tested performance of inflation-linked bonds in environments where there are short term inflation spikes might not look as attractive as other assets. 

However, this doesn’t mean that they won’t be a good inflation hedge going forward. If, for example, investors lose faith in the ability of central banks to control inflation then inflation expectations could rise and TIPS would provide a good portfolio hedge against this.

So are TIPS a good inflation hedge? Yes they are. But, you may need to manage your expectations. 

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Ed Studd

CEO, Zermelo

Ed is passionate about helping institutional investors meet their goals through better custom solutions. Prior to Zermelo, he gained extensive experience across asset management, investment banking and investment consulting.