April 1, 2021 | Expert Perspective

The potential for higher inflation: What can you do about it?

Gemma Wright-Casparius, portfolio manager, global rates, Treasuries/TIPS

Gemma Wright-Casparius
Portfolio Manager, Global Rates, Treasuries/TIPS

Katy Righi, senior product manager, taxable bonds

Katy Righi, CFA
Senior Fixed Income Specialist

Key points:

  • Investing in Treasury Inflation-Protected Securities (TIPS) can make sense, both as a tactical position given today's macroeconomic backdrop and as a long-term strategic fixed income allocation.
  • You should consider the client's funding source for the allocation and any trade-offs to risk/return from other fixed income factors like duration and credit.
  • We do not yet see a departure from long-run inflation trends, but risks to the upside have increased.

Like many advisors, you're probably concerned about the potential for higher inflation, and you're considering your options to help maintain real values or yield in your client portfolios.

It's not hard to see why. The rate of COVID-19 vaccinations in the U.S. is accelerating, raising hope for a robust postpandemic economy. Federal Reserve Chairman Jerome Powell has said the central bank will tolerate temporary inflation spikes above the Fed's long-run inflation target of 2%. And the U.S. government just issued $1.9 trillion in stimulus, with another round of stimulus now being discussed.

The question is: Will inflation see a sustained move upward or just a temporary boost? In either case, what can you do to help your clients?

Long-term trends

We believe that long-term inflation remains anchored by well-established structural trends. Those trends include population demographics, income inequality, globalization, and technology enhancements. These forces have been decades in the making and are not easily reversed. To learn more, read Vanguard's report, Megatrends: The economics of a graying world (login required).

The recent measures enacted through fiscal and monetary policy are meant to close an output gap caused by the pandemic. Sustained higher inflation would need to be achieved through additional measures and higher growth. However, we believe that while there will be cyclical bursts of inflation, we won't see runaway inflation anytime soon.

Inflation in the short to medium term

We have already seen the market price in higher inflation expectations. Market pricing of inflation is close to the upper end of the historical range, but we believe near-term risks are still skewed to the upside.

The potential for a short-term inflation overshoot is real, as macroeconomic factors, higher commodities prices, and the base effects of the very low inflation in 2020 can gradually push up market expectations.

Additionally, any weaker-than-expected data will only serve to reinforce the accommodative stance of the Fed.

Inflation expectations have been increasing from very low levels last year

This line chart shows the 10-year U.S. Treasury yield, the 10-year TIPS yield, the 10-year breakeven inflation (BEI) rate, and the Federal Reserve’s target inflation rate of 2% a year. The 10-year breakeven inflation rate rose above the Fed’s target in early 2021. The 10-year Treasury yield turned higher in September 2020. The 10-year TIPS yield turned higher earlier this year.

Source: Vanguard calculations, using Bloomberg data, as of March 18, 2021.

How TIPS can help strategically

You might consider TIPS to help protect the value of, and income from, your clients' fixed income portfolios. The principal of a TIPS bond rises—and falls—with the nonseasonally adjusted Consumer Price Index, and the coupon payment is also recalculated off this adjusted principal amount. This is how TIPS can deliver inflation protection and a real return. On the other hand, nominal Treasury bonds deliver a fixed coupon amount, so inflation can chip away at a nominal bond's real return.

For your clients who may be more sensitive to potential increases in inflation due to near-term income needs—particularly those in retirement or with known liabilities—having an allocation to TIPS can be a helpful hedge against inflation risk. Additionally, TIPS are not included in the Bloomberg Barclays U.S. Aggregate Bond Index, and thus, having an allocation to TIPS can provide additional diversification benefits not achieved through investing in standard market indexes.

How TIPS can help tactically

If you are considering a more tactical allocation to TIPS, then compare your inflation expectations with those that have already been priced into the market.

This is where the breakeven inflation (BEI) rate is critically important for TIPS investors. The formula is simple: Take the yield on a nominal U.S. Treasury bond and subtract the yield on the same-maturity TIPS bond. The resulting rate represents the market's view of the average inflation level over that time horizon. For example, as of March 19, 2021, the 10-year BEI rate was 2.31%, meaning investors expect the inflation rate to be an annualized 2.31% over the next 10 years.

Inflation expectations at historically rich levels

This box-and-whisker chart shows that both the 2-year and the 10-year breakeven inflation expectations are now trading at high levels. The 2-year BEI rate is at the 91st percentile, while the 10-year breakeven rate is at the 70th percentile.

Source: Vanguard calculations using Bloomberg data, from October 27, 2004, to March 18, 2021.

This rate helps inform a relative-value decision between like-maturity nominal Treasuries and TIPS. If you think inflation is more likely to be higher than 2.31% over the next 10 years, then you are better off holding TIPS than nominals so that you can benefit from higher-than-expected inflation. And vice versa, if you think that inflation is likely to disappoint market expectations, then you are better off holding nominals than TIPS. If you think a 2.31% inflation rate sounds about right, then you are indifferent between the two sectors. That's why this rate is called the break-even inflation rate—it's the inflation rate at which you are indifferent about owning Treasuries versus TIPS.

Other key risk factors: Duration and credit

Many investors buy TIPS for the inflation protection but fail to consider the other important risk factors in fixed income. The broad TIPS market had a nominal duration of 7.98 years as of March 19, 2021, and no credit risk since the issuer is the U.S. Treasury. If you are considering buying a TIPS fund or ETF for a client portfolio, it's important to decide how you will fund the allocation and how the overall duration or credit risk of their fixed income portfolio might change.

For example, if your client has cash on hand and is just interested in inflation protection without significantly altering overall portfolio duration, an allocation to short-term TIPS might make sense. If the client is considering funding a TIPS allocation from a portfolio that reflects the broad fixed income market, or from a broad Treasury allocation, and wants to maintain a consistent level of duration, a broader TIPS allocation could be suitable. If you are considering an allocation to TIPS from other credit sectors like corporate bonds, then the credit risk of the portfolio may decline, resulting in broader long-run return implications.

Your next decision, then, is whether to use an index fund, ETF, or actively managed fund.

At Vanguard, you'll find highly experienced TIPS traders, analysts, and portfolio managers across the Fixed Income Group, both on the active and on the index management teams. We also have a dedicated Treasury and Inflation specialist team that is responsible for evaluating active opportunities in this space. The TIPS sector is nuanced, and a fixed income manager with significant depth of experience and insights may be able to extract additional value from this market in the form of relative-value, yield-curve, or active-alpha trades, depending on the mandate of the product.

Vanguard products focused on TIPS

Vanguard Inflation-Protected Securities Fund Admiral™ Shares

Vanguard Short-Term Inflation-Protected Securities ETF

Notes:

  • Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Note that some or all of the income from the U.S. Treasury obligations held in the fund may be exempt from state or local taxes.
  • U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
  • Vanguard Inflation-Protected Securities Fund and Vanguard Short-Term Inflation-Protected Securities ETF invest 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 funds are 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 funds' 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 funds.
  • CFA® is a registered trademark owned by CFA Institute.