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The Hard Truth About TIPS

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What You Need to Know

  • Treasury inflation-protected securities are a common holding of the target date funds that millions of workers use to save for retirement.
  • A healthy couple following the 4% rule has an 80% chance of outliving savings invested in TIPS at today's rates.
  • Advisors may think they can get better fixed income returns elsewhere, but rewards for taking risk are small in this inflated market.

According to the Investment Company Institute, 52% of American workers are saving for retirement in target date funds.

The most popular Vanguard family of target date funds places 20% of a worker’s retirement savings in Treasury inflation-protected securities at age 72. Today, the yield on five-year TIPS is -1.91%. In five years, the investor will get $908 in spending power from every $1,000 invested today in TIPS.

Some advisors will look at today’s TIPS rates and believe that they can take wealth out of a TDF, invest it in other bonds, and get a higher return while charging an AUM fee. To believe otherwise means acknowledging an investment reality that many advisors haven’t yet accepted.

This is the trouble with TIPS.

TIPS and the 4% Rule

The so-called 4% rule assumes that an investor can maintain an inflation-adjusted lifestyle equal to 4% of their initial savings at retirement. A retiree who buys $500,000 worth of TIPS on their 65th birthday could withdraw $1,666 a month of real spending ($20,000, or 4% of $500,000, per year) until a couple of months after they turn 86. Of the 20% of savings a target date retiree invests in TIPS at today’s rates, this money will last 21 years if they follow the 4% rule. 

Healthy couples have a more than 80% chance of outliving savings invested in TIPS at today’s rates if they follow the 4% rule.

It’s easy to focus on the negative real return on TIPS as a way to dismiss their value as an investment. But TIPS are really a combination of two assets — a Treasury bond and an inflation hedge. The inflation hedge gives investors the ability to lock in a rate of inflation on their Treasury bond investments over time. 

For example, the five-year Treasury bond yield is 1.27% today. By choosing TIPS instead of a nominal Treasury, the investor is able to lock in an inflation rate of 3.16%. The 3.16% is mostly the market’s expectation of the average inflation rate over the next five years, but also represents the value investors are willing to place on certainty.

Federal Reserve economists find that the inflation risk premium has varied over time, but on average is around 10 basis points (0.1%). In other words, investors get only a tiny bonus from bearing inflation risk instead of transferring it to the government.

In fact, investors who are simply willing to acknowledge the reality of negative real safe bond yields may be getting paid a premium for buying inflation protection. Larry Swedroe, chief research officer at Buckingham Wealth Partners, suggests using the Federal Reserve Bank of Philadelphia’s Livingston Survey of inflation forecasts from economists in industry, government, banking and academia as a reasonable estimate of inflation expectations.

The most recent survey pegged near-term inflation expectations at 3.7%, which is higher than the spread between TIPS and Treasurys. This isn’t the first time that the spread indicates that investors might be getting paid to buy inflation insurance. 

Economists such as Boston University professor Zvi Bodie argue that TIPS are particularly valuable for retirees because they take away a significant source of lifestyle risk for a modest cost in average expected spending.

In other words, the 0.1% is a small price to pay for lifestyle insurance. David Blanchett, head of retirement research at PGIM, which offers a target-date investment (the DayOne series) that incorporates TIPS into their retirement portfolio, believes that TIPS provide value to retirees even at today’s rates.

“While the yields on TIPS are negative, the explicit inflation protection can be especially valuable to certain investors, especially retirees, who want an investment that tracks the underlying risk of their spending needs.” To Blanchett, annual retirement spending should be viewed as a liability, and a fixed income investment should be judged on its ability to meet the after-inflation lifestyle. 

 “Sure, there is a ‘cost’ associated with owning TIPS, but the benefit, like owning other forms of insurance, is that if inflation is high, the investor is covered,” Blanchett says. “While the relatively high spread versus nominal Treasurys may make them unattractive for some investors, there are certainly others that will be more than happy to purchase them under the assumption the yield differences accurately reflect expectations around risk.”

Back to Basics

It’s worth going back to basic finance theory to understand why investors take risk. In general, investors prefer certainty to risk because they are risk-averse. They will pay less for an asset that has the same expected payout (yield, dividend, capital gain) that is risky compared with an asset with a certain payout.

The risk aversion of the market determines how much of a discount investors need to buy a risky asset. In other words, risky assets should be cheaper because people prefer certainty, and lower prices for the same expected payout means higher returns on average.

Corporate bonds have purchasing power uncertainty and credit risk. TIPS take away both. If inflation continues to go up by 5% per year, the $1,000 invested in nominal Treasurys today will buy about $60 less than $908 worth of stuff in five years. If inflation is only 2%, then the investor might have an extra $50 to spend.

The real rate of inflation is unknown, so your client faces a range of spending possibilities in five years. Is that a risk they want to bear at such a modest potential risk premium?

The Credit Premium Conundrum

The good news is that investors don’t have to buy Treasurys at all. They can invest in corporate bonds that have historically outperformed Treasurys by rewarding investors for accepting a credit premium. 

The bad news is that this premium may not be much higher than the premium investors get for accepting inflation risk. And since risk is real, you’ve just layered on another slice of future spending volatility that a client must be willing to accept.

Too many advisors view the credit risk premium as just a bonus that smart investors get for avoiding Treasurys. Swedroe points out that the actual performance difference between long-term government and long-term corporate bonds is “basically zero or negative after fund fees.” 

Reaching for yield by increasing credit risk can seem like a better way to energize bond returns.  Swedroe notes that “today, the Vanguard high-yield fund (which isn’t junk) has about a 3.5% yield with a four-year duration.” But this extra yield comes at a cost of both higher volatility and higher correlations with risky assets.

“You’re taking significant credit risk, and when COVID happened that fund got crushed,” he explains. “The main purpose of fixed income should be to dampen the risk of a portfolio to an acceptable level. In 2008, junk bonds dropped by half. How do you rebalance your portfolio? The same thing happened in COVID — you have to look at correlations. Correlations are average and correlations drift.”

Blanchett agrees that “while high-yield bonds can be attractive to some investors, they are incredibly risky as ‘bond’ investments go, and have correlations with the market that actually increase (versus decrease) during down markets, which is the opposite [of what] you want from a diversifier asset class like fixed income.”

In fact, high-yield bonds have historically had about a 0.60 correlation coefficient with U.S. equities, while Treasurys have had a correlation near zero. Practically, this means that an advisor can construct a portfolio using Treasurys that offers a higher expected return for the same amount of risk by increasing the allocation to stocks.

Although counterintuitive, the improved diversification value of Treasurys can help an advisor increase allocation to risky assets and achieve a more efficient portfolio. Theoretically, since TIPS reduce spending risk even more, an advisor can take even more risk with TIPS.

The Search for Fixed Income Returns

The flood of liquidity has left many investors with few attractive options. Fixed income investors are stuck with negative real returns for short maturity bonds, and only a modest premium for long-term bonds. S&P 500 valuations as a percentage of trailing 10-year profits are higher than at any point in U.S. history other than the tail end of the tech bubble (after which 10-year S&P returns were negative).

According to Bianco Research, U.S. households hold $3.5 trillion in checkable deposits — up from just $800 billion in the third quarter of 2019. There are record amounts of cash on the sidelines sitting in accounts that will lose at least 5% of purchasing power in 2021 waiting for something appealing to turn up. 

The European Central Bank recently warned that the risk of inflation would punish a range of leveraged investments that could fall sharply in value of interest rates rose in tandem. While Western economies are once again heating up post-pandemic, the ECB warned of “pockets of exuberance in credit, asset and housing market as well as higher debt levels in the corporate and public sectors.”

Easy borrowing at low rates to leverage purchases of assets such as real estate may seem safe, but could lose value quickly if interest rates rise. The ECB also warned that “more exotic segments, such as crypto asset markets, also remain subject to speculative bouts of volatility.” 

Investors who have tried to reach for yield by increasing credit risk face the possible double whammy of rising interest rates and the deterioration of credit markets during a flight to safety.

Another Option

Rather than hoping to juice returns through a credit risk premium, Swedroe suggests considering the capture of a premium through illiquid private equity investments such as interval funds.

Interval funds do not provide immediate liquidity to investors hoping to sell shares back to the fund company, but occasionally offer investors the opportunity to redeem shares to capture investment returns. These funds seek investments in highly illiquid, income-producing assets that offer higher yields than publicly traded fixed income investments.

According to Swedroe, “any private asset has a big illiquidity premium” because “most people want liquidity and they pay a lot to get it. Wealthy investors can take advantage of an illiquidity premium. Most people are not familiar with the asset class.”

Although Swedroe encourages many clients to invest in interval funds because “their Sharpe ratios are much higher” than those of comparable liquid investments, he cautions that “you’re dealing with unrated securities. You’ve really got to trust the manager.” 

Recent research on the excess performance of private equity over publicly traded investments on the aggregate is mixed, however. A pair of articles (article 1, article 2) published in 2020 in the Journal of Investing found little evidence that private equity investment performance has been higher than publicly traded investment performance in recent decades. 

The hard truth about TIPS is that they offer returns that are unattractive. But they may be more attractive than the alternative of accepting greater risk in an inflated market where the reward for taking risk is so small. 

Advisors need to ask themselves whether greater investment risk to capture these premiums is truly in the client’s best interest, or whether by taking risk they are merely seeking the comfort of uncertainty to avoid the depressing reality offered by risk-free investments today.