Pro TIPS: Get the most out of inflation-protected bonds

As inflation continues to dominate market narratives, we are using Treasury Inflation-Protected Securities (TIPS) across many of our active bond portfolios.

With recent inflation data above market forecasts, TIPS may be top of mind for advisors. However, TIPS performance is driven by both interest rate risk and inflation expectations—and this can result in unexpected scenarios, for example, TIPS having negative performance in a high-inflation environment. Moreover, sometimes the better strategy is not to own TIPS outright, but instead through a hedged position that isolates your exposure to only the “breakeven inflation” risk inherent to TIPS.

Like much of the bond market, the yield earned by TIPS investors, known as real yield, is at the most attractive levels in over a decade. A long-term allocation to TIPS can be a helpful solution for clients who are more sensitive to unexpected inflation shocks and want to take advantage of these attractive real yield valuations. Our team added TIPS breakevens across our active government funds and some of our multi-sector portfolios.

Sticky inflation

After a consistent downtrend in 2023, inflation has been stabilizing at levels above the Fed’s target. Over the first quarter of 2024, the Consumer Price Index (CPI) and Personal Consumption Expenditures Index (PCE) posted larger-than-expected gains.

Inflation has been sticky recently because of the tight labor market, elevated shelter costs, and a reversal in goods disinflation, which primarily drove last year’s downtrend.

Near term, we see potential for further inflation volatility. Long term, we expect inflation to moderate to the Federal Reserve’s target as tighter monetary policy takes effect.

Not always straightforward

You want to protect your clients from adverse outcomes or, if you can, capitalize on inflation-related market moves now. Just remember that TIPS performance is not always straightforward.

• TIPS involve interest rate risk: Just like any other type of bond, buying TIPS introduces interest rate risk to a portfolio. If rates rise and inflation expectations are steady (or also rise, but not as much as yields), real yields also rise, potentially leading to negative returns in TIPS. The negative return impact from rising yields can more than offset the positive impact from the inflation adjustment, as was the case in 2022.
• TIPS outperform when inflation exceeds expectations: The real yield earned through owning TIPS is lower than the yield earned by a nominal Treasury investor, because of the assumption that inflation will occur and compensate the TIPS investor. If this assumed level of inflation priced into TIPS, known as “breakeven inflation,” occurred over the life of the bond, nominal Treasuries and comparable TIPS would have the same return. TIPS will outperform nominal Treasuries when actual inflation exceeds expected inflation and underperform nominals when actual inflation is lower than expected inflation.

Remembering these factors can help you avoid the surprise some investors experienced when they allocated to TIPS in 2021 when inflation began to rise. Rising interest rates in 2022 hurt TIPS like they did all bonds; TIPS returned –11.85% that year, better than U.S. Treasuries (–12.46%), but still negative total returns.¹

How we’re positioned

The upside risk to inflation, as well as the fact that inflation tends to be seasonally higher in the first half of the year, created an opportunity in TIPS. Our team added exposure across our active government funds and some of our multi-sector portfolios.

However, we hedged the duration risk of these positions to leave only exposure to breakeven risk—the risk that inflation expectations change in the near term. Breakeven trades can be set up by buying TIPS and selling a nominal Treasury or Treasury derivative, or vice versa, depending on the manager’s view on inflation. This positioning means our portfolios can benefit from higher-than-expected inflation while being hedged from the potential impact of rising rates.

The benefits of active

Allocating to TIPS requires skill. It’s difficult to predict the path of inflation and interest rates. Partnering with an active manager can allow your portfolio to benefit from opportunities the market presents without being exposed to unintended risks.

Our expertise spans the fixed income market, enabling the identification of the best opportunities across bond sectors at any given time. Experience, tools, and insight, as well as the flexibility active strategies provide, allow us to isolate and exploit precise risk factors—such as the breakeven inflation risk—to aim for consistent outperformance over time.

Vanguard Inflation-Protected Securities Fund

Vanguard Core Bond Fund

Vanguard Core Bond ETF

Vanguard Short-Term Treasury Fund

Vanguard Intermediate-Term Treasury Fund

1 Source: Bloomberg, as of December 30, 2022

Notes:

For more information about Vanguard funds or Vanguard ETFs, contact your financial advisor to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Investments in bonds are subject to interest rate, credit, and inflation risk.

The Vanguard Inflation-Protected Securities Fund invests in bonds that are backed by the full faith and credit of the federal government and whose principal is adjusted periodically based on inflation. The fund is subject to interest rate risk because although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa. The fund's quarterly income distributions are likely to fluctuate considerably more than the income distributions of a typical bond fund. Income fluctuations associated with changes in interest rates are expected to be low; however, income fluctuations associated with changes in inflation are expected to be high. Overall, investors can expect income fluctuations to be high for the fund.

Vanguard Core Bond ETF and Vanguard Core-Plus Bond ETF are not to be confused with the similarly named Vanguard Core Bond Fund and Vanguard Core-Plus Bond Fund. These products are independent of one another. Differences in scale, certain investment processes, and underlying holdings between the ETFs and their mutual fund counterparts are expected to produce different investment returns by the products.