Many investors who own Treasury Inflation-Protection Securities (TIPS) and TIPS mutual funds don’t realize that they may be taking a significant amount of interest-rate risk in exchange for their inflation protection, which may result in losses when rates begin to rise rapidly.
Shorter-maturity TIPS carry the same inflation adjustment as longer-term TIPS, but have less sensitivity to interest rates, which may be helpful in times of rising interest rates like what investors experienced in spring 2013.
- Investors may consider an inflation-protection investment strategy that avoids longer-term TIPS and seeks real returns through a strategy of using shorter-maturity TIPS and other shorter-duration1 assets, like floating-rate loans.
When it comes to interest-rate risk, not all TIPS are created equal. Historical correlations show that rising inflation often corresponds with periods of rising interest rates, which erode the value of fixed-income securities. Because of this, intermediate- and long-maturity TIPS, which many investors believe will protect them in times of rising inflation, may have too much interest-rate risk to achieve this protection. In 2013, the losses on TIPS due to interest-rate risk have outweighed the benefit of the inflation adjustment, leading to unexpected losses for inflation-worried investors.
At Eaton Vance, we understand investors’ need to earn a real return — one that exceeds inflation — without taking on an undue amount of interest-rate risk. We advocate a prudent inflation-protection strategy that offers the potential investors seek, balanced with the degree of risk they can assume in their portfolio. We think that one possible solution is to own shorter-maturity TIPS, which have the same inflation adjustment as longer-dated TIPS, but carry less interest-rate risk, as well as other higher-yielding, short-duration assets, which could allow investors to trade unwanted interest-rate risk for credit risk. We believe this approach may help protect purchasing power and offer investors a real return potential above inflation.
In this Insight, we outline the continued challenges for TIPS investors in the current environment and show how the potential solution of shortening duration and adding high-yielding assets like floating-rate loans and high-quality, short-duration commercial mortgage-backed securities (CMBS) may offer a more favorable approach to inflation protection. We begin with a closer examination of the interest-rate risk of longer-dated TIPS, a concept that not all TIPS investors may be mindful of.
The overlooked danger for TIPS investors: interest-rate risk
Investors in inflation-protected bonds have learned a painful lesson this year: TIPS have interest-rate risk as other bonds do. Inflation-protected bond funds returned an average of -6.28% for the year as of September 30, according to Morningstar, putting the fund category on course for its worst year of performance since TIPS were introduced in 1997. The size of losses on bonds that were designed to protect in inflationary environments has caught many investors off-guard.
In May, Federal Reserve (the Fed) Chairman Ben Bernanke surprised the markets by suggesting that quantitative easing (QE), the Fed’s seemingly perpetual monthly program of $85 billion in asset purchases, would end sooner than most investors had expected. His comments sparked a sharp sell-off in bond markets, with the yield on the 10-year U.S. Treasury nearly doubling from 1.6% to a high of 3% in early September. As a helpful reminder, nominal interest rates are the sum of real interest rates and inflation. In the scenario we saw this spring, nominal rates were rising as inflation expectations were falling. In other words, real rates were rising at a faster speed than nominal rates, causing particular pain to investors in longer-duration TIPS.
Unfortunately, most inflation-protected bond funds have historically held intermediate and long TIPS, which make them quite susceptible to changes in interest rates. The average duration, or sensitivity to interest rates, for inflation-protected bond funds is 6.39 years (as of September 30), according to Morningstar. Using simple bond math and assuming all other things are equal, a hypothetical 100-basis-point rise in interest rates would result in a 6.39% drop, on average, in the value of a fund’s portfolio.
For investors who bought intermediate and long TIPS to hedge against inflation, the losses thus far in 2013 have generally exceeded their expectations. This is significantly different than the past few years, when long-maturity TIPS benefited from the easy monetary policy actions by the Fed. Importantly, the outsized gains to long-maturity TIPS in 2011 and 2012 were not due to rising inflation, but, rather, to the decline in real interest rates as the Fed engaged in asset purchases. In this environment, longer-dated TIPS had a significant advantage over short-maturity TIPS, thanks to the longer duration of the bonds; as real rates declined, the price of TIPS increased more than both their shorter-duration and nominal Treasury counterparts.
Why inflation protection is still important
Even moderate inflation can significantly erode purchasing power over time (Figure 1). That’s where shorter-duration TIPS may bring value to a portfolio. TIPS offer coupon payments and a value at maturity that change along with the U.S. consumer price index (CPI), so an increase in inflation leads to a positive adjustment in TIPS, thereby helping to protect investors’ purchasing power.
But as astute investors will point out, there has been no rapid increase in inflation this year. Although the Fed is explicitly attempting to produce inflation in the U.S. by pumping unprecedented amounts of liquidity into the economy and capital markets, high inflation simply hasn’t materialized; CPI has climbed just 1.2% in the 12 months through September, well below the Fed’s own unofficial target of 2%.
To be sure, we believe both interest rates and inflation will rise over the intermediate term. The Fed’s easy monetary policy and unprecedented intervention in markets have helped push interest rates below fair value, in our opinion. If our view is correct, normalization — like the end of the Fed’s QE program — could push rates back toward fair value, creating losses that are likely to exceed inflation in intermediate- and longer-term TIPS portfolios. Historical data show that higher interest rates have a meaningful correlation with higher inflation (Figure 2). In this scenario of rising interest rates and rising inflation, longer-dated TIPS may likely see the benefit of the inflation adjustment overshadowed by price erosion. In this environment, investors are challenged to find investments that earn returns in excess of inflation without taking on a great deal of interest-rate risk. We believe in a prudent, multipronged inflation-protection strategy that is mindful of interest-rate risk and potentially offers both an income advantage and diversification benefits. The first step to achieving this goal is to understand how shorter-duration TIPS may lower interest-rate risk.
One potential answer: shorten the duration of your inflation protection
If real interest rates continue to rise as we believe they will, longer-dated TIPS could produce further losses despite the boost from the CPI adjustment. One possible answer for worried investors may be short-duration TIPS, which can have much lower sensitivity to interest rates than longer-dated TIPS, but have the same inflation adjustment as their longer-dated counterparts.
Consider a hypothetical example where real rates rise 2% and inflation rises 3% (Figure 3). The key concept to understand here is that, despite the different maturities, both TIPS have the same inflation adjustment. If interest rates are expected to rise, it doesn’t make sense to hold longer-dated TIPS that offer the same inflation adjustment as shorter-duration TIPS, but carry more interest-rate risk.
By choosing shorter-duration TIPS over longer-maturity TIPS, investors can lower the interest-rate risk in their portfolio. But shorter-duration TIPS have very low—in some cases negative—yields. To compensate for the lack of yield in short TIPS, one possible solution is to combine short TIPS with asset classes that carry very little interest-rate risk and offer a potential yield advantage, such as floating-rate loans.
Floating-rate loans and CMBS may help with an income boost
Floating-rate loans can offer compelling yields along with a hedge against rising interest rates. While floating-rate loans provide attractive income potential, they carry virtually none of the interest-rate risk of conventional, fixed-rate bonds — but also have a higher correlation to inflation (Figure 4). The regular reset of the interest rate on a floating-rate loan means that its interest-rate duration is very small, effectively near zero. Floating-rate loans also offer a senior position in an issuer’s capital structure. By employing floating-rate loans in a portfolio alongside shorter-duration TIPS, investors substitute a portion of their interest-rate risk with credit risk. As inflation has historically increased as the business cycle turns upward, we believe this exchange of risks
However, we see a potential benefit in a strategy that takes one additional step in order to hedge against inflation. By utilizing swaps on the floating-rate loans, investors can exchange the Libor-based income received from the loans for payments based on changes in CPI. If inflation subsequently rises faster than Libor, which we believe will happen based on current Fed policy, the strategy of using swaps tied to CPI should prove helpful. However, there is the risk that inflation does not increase as quickly as Libor, which could potentially lead to losses on the swapped cash flows.
In addition to floating-rate loans, investors may want to consider high-quality, short-duration CMBS as another asset class that can offer a yield advantage with shorter duration. Again, swapping CMBS income for income based on changes in CPI may help hedge against increases in inflation.
Which path to inflation protection will you take?
As we stated, not all inflation protection is the same. TIPS investors must be mindful that even with the inflation adjustment they receive from TIPS, interest-rate risk can materially affect bond values. The good news for TIPS investors who have seen poor returns in 2013 thus far is that there may be a simple way to avoid these pitfalls, while still maintaining their inflation protection.
We have made the case that employing a strategy that exchanges the interest-rate risk inherent in TIPS for short-duration credit risk is one way to help realize the goal of a real return. While we believe an inflation-protection strategy may ultimately prove beneficial, it does need to be properly implemented. Professional investment managers, executing a well-designed portfolio strategy like the one described in this Insight, may be able to help navigate the volatility in markets during periods of rising interest rates, like what transpired earlier this year when it appeared the Fed would taper its QE purchases.
1Duration is a measurement of interest-rate sensitivity. Securities with longer durations tend to be more sensitive to interest rate changes than securities with shorter durations.
S&P 500 Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance.
Barclays Capital U.S. Aggregate Bond Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.
BofA Merrill Lynch U.S. Inflation-Linked Treasury Index is an unmanaged index comprised of U.S. Treasury Inflation-Protected Securities with at least $1 billion in outstanding face value and a remaining term to final maturity of greater than one year.
BofA Merrill Lynch U.S. 1-5 Year Inflation-Linked Treasury Index is an unmanaged index comprised of U.S. Treasury Inflation-Protected Securities with at least $1 billion in outstanding face value and a remaining term to final maturity of at least one year and less than five years.
Credit Suisse Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.
Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index.
About Asset Class Comparisons
Elements of this report include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested.
The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risks and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emerging-market bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum.
Costs and expenses associated with investing in asset classes shown will vary, sometimes substantially, depending upon specific investment vehicles chosen. No investment in the asset classes shown is insured or guaranteed, unless explicitly stated for a specific investment vehicle. Interest income earned on asset classes shown is subject to ordinary federal, state and local income taxes, except U.S. Treasury securities exempt from state and local income taxes) and municipal securities (exempt from federal income taxes, with certain securities exempt from federal, state and local income taxes). In addition, federal and/or state capital gains taxes may apply to investments that are sold at a profit. Eaton Vance does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision.
An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Interest payments on inflation-linked securities may vary widely and will fluctuate as principal and interest are adjusted for inflation. Investments in inflation-linked securities may lose value in the event that the actual rate of inflation is different than the rate of the inflation index. There can be no assurance that the liquidation of collateral securing an investment will satisfy the issuer’s obligation in the event of nonpayment or that collateral can be readily liquidated. The ability to realize the benefits of any collateral may be delayed or limited. As interest rates rise, the value of certain income investments is likely to decline. Commercial mortgage backed securities (CMBS) are subject to credit, interest-rate, prepayment and extension risks. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher-rated investments. Derivative instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk.
About Eaton Vance
Eaton Vance Corp. (NYSE: EV) is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors.
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