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As of October 29, 2021, Treasury Inflation Protected Securities (known as TIPS) have a duration of 7.7 years. Duration is a measure of a bond or bond fund’s sensitivity to interest rate changes. The higher a bond’s duration, the more sensitive it will be to changes in interest rates. That means if U.S. Treasury rates rise 1%, the price of TIPS could fall 7.7%. You may be thinking to yourself, “Wait. I thought TIPS protected investors from rising interest rates, don’t they?” The short answer is “not quite.”
TIPS can help protect investors from rising inflation expectations, not inflation itself, and not specifically from rising interest rates. So, while our research does indicate that TIPS have historically outperformed Treasurys during periods of rising interest rates, hedging interest rate risk (rather than inflation expectations) has actually been a more direct—and more effective—solution.
Interest Rate Hedged Corporate Bonds Have Outperformed TIPS During Rising Interest Rates - Comparison of Indexes
Source: Bloomberg, 12/31/2013 through 9/30/2021. Average performance based on quarterly changes in the 10-Year Treasury yield. Rising rate periods are any calendar quarter in which the 10-Year Treasury yield increased. Interest Rate Hedged Bonds are represented by the FTSE Corporate Investment-Grade (Treasury-Rate Hedged) Index. “Treasurys” are represented by the Bloomberg U.S. Treasury Index. TIPS are represented by the Bloomberg U.S. TIPS Index.
The Current Environment Could Create Headwinds for TIPS
Inflation expectations can certainly rise when interest rates rise, and that’s why, as the chart above shows, TIPS have historically outperformed regular Treasurys when rates have risen. However, the FTSE Corporate Investment Grade (Treasury Rate-Hedged) Index has performed even better because interest rates can rise even if inflation expectations don’t. In fact, that’s what the Fed’s tapering program is intended to achieve. The goal is to create a rise in interest rates that comes either: a) without accompanying rising inflation expectations; or b) with rate increases in excess of rising inflation expectations. And that is a recipe for disappointing TIPS performance.
Understanding TIPS also requires a quick briefing on the difference between inflation expectations and current inflation. TIPS typically perform well when future expectations of inflation increase, not when current measures of inflation rise. TIPS have performed well so far in 2021, up roughly 5% through 10/29/21, as tracked by the Bloomberg U.S. TIPS Index. That means higher inflation expectations are potentially already reflected in TIPS prices.
Breakeven inflation rates are calculated by looking at the difference between the yields on TIPS versus a nominal (or typical) Treasury at the same maturity. Breakeven rates help provide insight into what investors expect the rate of inflation will be over a specified time period. Let’s look at those expectations below.
Breakeven Expectations Could Face Pressure from Transitory Inflation
Source: Bloomberg, as of 10/29/21.
The 10-year breakeven rate stood at 2.6% at the end of October—higher than the Fed’s 2% inflation target. If investors decide that current inflation levels are likely transitory, breakeven inflation expectations could fall, putting pressure on TIPS performance versus the broader fixed income market.
Consider an Interest Rate Hedged Bond Strategy Instead of TIPS
The present period of extremely low real interest rates and elevated inflation expectations may be the wrong time for investing in TIPS. Moving forward, the Fed likely wants real interest rates to rise and inflation to be kept in check. With interest rate risk and credit risk being the primary drivers of return for bond strategies, now may be the time to tilt toward credit risk. Consider interest rate hedged bond strategies, which invest in portfolios of investment grade or high yield bonds with built-in hedges directly targeting the impact of rising Treasury rates.
One strategy for investors that focuses on investment grade fixed income investments includes ProShares Investment Grade—Interest Rate Hedged (IGHG).
IGHG is an innovative bond ETF that:
- Offers return potential from a diversified portfolio of investment grade corporate bonds.
- Has an interest rate hedge that uses short Treasury futures to target zero interest rate risk.
- For more information, visit ProShares.com
This information is not meant to be investment advice. There is no guarantee that the strategies discussed will be effective. Investment comparisons are for illustrative purposes only and not meant to be all-inclusive.
Any forward-looking statements herein are based on expectations of ProShare Advisors LLC at this time. ProShare Advisors LLC undertakes no duty to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Investing is currently subject to additional risks and uncertainties related to COVID-19, including general economic, market and business conditions; changes in laws or regulations or other actions made by governmental authorities or regulatory bodies; and world economic and political developments.
Investing involves risk, including the possible loss of principal. This ProShares ETF entails certain risks, including risks associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Please see summary and full prospectus for a more complete description of risks. There is no guarantee any ProShares ETF will achieve its investment objective.
Bonds will decrease in value as interest rates rise.
Short positions in a security lose value as that security's price increases.
The fund concentrates its investments in certain sectors. Narrowly focused investments typically exhibit higher volatility.
IGHG does not attempt to mitigate factors other than rising Treasury interest rates that impact the price and yield of corporate bonds, such as changes to the market’s perceived underlying credit risk of the corporate entity. IGHG seeks to hedge investment grade bonds against the negative impact of rising rates by taking short positions in Treasury futures. These positions lose value as Treasury prices increase. The short positions are not intended to mitigate credit risk or other factors influencing the price of the bonds, which may have a greater impact than rising or falling interest rates. Investors may be better off in a long-only investment grade investment than investing in IGHG when interest rates remain unchanged or fall, as hedging may limit potential gains or increase losses. No hedge is perfect. Because the duration hedge is reset on a monthly basis, interest rate risk can develop intra-month, and there is no guarantee the short positions will completely eliminate interest rate risk. Furthermore, while IGHG seeks to achieve an effective duration of zero, the hedge cannot fully account for changes in the shape of the Treasury interest rate (yield) curve. IGHG may be more volatile than long-only investment grade bond investments. Performance of IGHG could be particularly poor if investment grade credit deteriorates at the same time that Treasury interest rates fall. There is no guarantee the fund will have positive returns.
Carefully consider the investment objectives, risks, charges and expenses of ProShares before investing. This and other information can be found in their summary and full prospectuses. Read them carefully before investing.
"FTSE®" and "FTSE Corporate Investment Grade (Treasury Rate Hedged)" have been licensed for use by ProShares. FTSE is a trademark of the London Stock Exchange Plc and The Financial Times Limited and is used by the FTSE International Limited ("FTSE") under license. ProShares have not been passed on by FTSE or its affiliates as to their legality or suitability. ProShares based on the FTSE Corporate Investment Grade (Treasury Rate Hedged) Index are not sponsored, endorsed, sold or promoted by FTSE or its affiliates, and they make no representation regarding the advisability of investing in ProShares. THIS ENTITY AND ITS AFFILIATES MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO PROSHARES.
ProShares are distributed by SEI Investments Distribution Co., which is not affiliated with the funds' advisor.
