U.S. Treasury Inflation-Protected Securities (TIPS) didn’t generate positive returns in 2022, despite inflation hitting the highest levels since the early 1980s.¹ Some investors may find this development confusing and wonder if adding inflation-protected bonds to their portfolios makes sense.

Whether inflation simmers down from here or surges again, we believe TIPS can play an important role in portfolios for two key reasons:

• TIPS help investors hedge against inflation
• they can potentially provide diversification to traditional portfolios.

What are TIPS?

TIPS are U.S. government bonds with principal values that are adjusted based on changes in inflation. A bond’s principal, also known as its face or par value, is the amount of money the bond issuer agrees to pay investors when the bond matures.

In Canada, the Bank of Canada used to issue 30-year Canada real return bonds (RRBs), which are inflation-protected instruments similar to U.S TIPS. However, as of November 2022, the government announced RRBs will no longer be issued.² As Canada and U.S. Consumer Price Indices have historically been highly correlated,³ U.S. TIPS may offer an alternate way to source inflation protection in their portfolios for Canadian investors.

Here’s a deeper look at how TIPS work, according to the U.S. Treasury Department: ⁴

• The TIPS’ principal increases with inflation and decreases with deflation, as measured by the U.S. Consumer Price Index (CPI). When TIPS mature, you are paid the adjusted principal or original principal, whichever is greater.
• TIPS pay interest twice a year at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

Additionally, the total return of a TIPS portfolio will be impacted by changes in interest rates as well as changes to the market’s expectations for future inflation.

How have TIPS performed recently?

After generating positive total returns for investors in 2021, TIPS produced negative total returns in 2022.⁵ Again, that’s despite U.S. CPI inflation posting its largest year-over-year increase since November 1981.⁶

Two developments may help explain this apparent contradiction (Exhibit 1):

• First, interest rates jumped after the Federal Reserve started raising interest rates; yields on the 2-year U.S. Treasury note and 10-year U.S. Treasury note rose 209 basis points and 154 basis points, respectively from March 31, 2022, to December 31, 2022.⁷ Higher rates caused bond prices — which move in the opposite direction of yields — to decline, including on TIPS securities. While TIPS outperformed their nominal counterparts⁸ in 2022, the additional rises in U.S. CPI inflation were not enough to offset the losses resulting from rising rates.
• Second, as noted above, the total return of TIPS is affected by inflation expectations, not just actual U.S. CPI prints. In 2021, demand for TIPS securities rose in conjunction with an increase in inflation expectations. From May 2021 to December 2021, 2-year breakeven rates — the difference between yields on TIPS and nominal Treasuries with the same duration, and the market’s expectation of future inflation — moved higher. As a result, TIPS outperformed traditional bonds in 2021 as both actual and expected inflation rose while interest rates stayed flat. In other words, TIPS rose in price ahead of the actual published change in U.S. CPI.⁹

Exhibit 1: Breakdown of TIPS total returns by driver beginning in 2021

Source: Bloomberg as of 12/31/2022. The TIPS Total Return is the return of the Bloomberg U.S. Treasury Inflation-Linked Bond Index, the Nominal Treasury Return is the return of The Bloomberg U.S. Treasury Index adjusted to be on equal duration of the Inflation-Linked Index, and the Benefit from Inflation Expectations is the difference between the two. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual Fund performance.

Fast forward to the present and two-year breakeven inflation rates are at 2.3%, significantly lower than the most recent year-over-year U.S. CPI change of 7.1%.¹⁰ This suggests the market is expecting inflation to moderate in the coming year.

While U.S. CPI inflation has started decelerating from the 9.1% level seen earlier this summer, we believe inflation is likely to remain above the Fed’s 2% target for some time. Exactly how high and for how long will depend on several factors that are difficult to predict. But if inflation does surprise higher, TIPS can offer a hedge against further inflation risk, while also providing current income. Moreover, TIPS yields are at their highest levels since 2009,¹¹ providing a potential attractive entry point for investors.

Where do TIPS fit into a portfolio?

Most traditional broad fixed-income benchmarks, such as the Bloomberg US Aggregate Index and the FTSE Canada Universe Bond Index, do not include inflation-protected bonds. As a result, investors may not own any inflation protection in their core bond allocations. TIPS ETFs offer an easy and efficient way to add diversification into portfolios.

TIPS also provide investors an opportunity to diversify against other major asset classes. The correlation of TIPS to the S&P 500 was just 0.4 in the past decade, 0.4 to the S&P/TSX and 0.6 to U.S. high-yield corporate debt (Exhibit 2).¹⁰ Correlation is a measure of the relationship between assets, as represented by a value range of -1 to 1; the lower the number, the weaker the relationship.

Exhibit 2 – Correlation of TIPS to traditional asset classes

Source: Bloomberg as of 12/31/2022 using monthly returns over the previous ten years. U.S. TIPS are represented by the Bloomberg U.S. Treasury Inflation-Linked Bond Index and U.S. Nominal Treasuries are represented by the Bloomberg U.S. Treasury Index, High U.S. Yield Corporates are the Bloomberg U.S. High Yield Corporate Index, U.S. Aggregate Index is the Bloomberg U.S. Aggregate Bond Index, Canada Universe Bond Index is the FTSE Canada Universe Bond Index, S&P 500 is the S&P 500 Index and S&P/TSX is the S&P/TSX Composite Index. Past correlations are not indicative of future correlations.

How to obtain TIPS exposure with RBC iShares

Just as you might own fixed income to hedge against the possibility for declines in the equity market, investors could consider having at least some allocation to TIPS to hedge against the possibility of higher-than-expected inflation. In addition, TIPS have historically provided investors diversification benefits, making them a core element to a well-rounded portfolio.

The iShares 0-5 Year TIPS Bond Index ETF (CAD-Hedged) (XSTH) provides access to a diversified basket of short-term U.S. TIPS in a single fund, allowing investors to gain inflation protection while limiting duration risk. The currency non-hedged unit (XSTP) and U.S. dollar-denominated unit (XSTP.U) are also available.

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