By Victor Haghani and James White ¹

We’ve been hearing a lot of this:

In mid-2020, I got worried about inflation. I decided to protect myself against a jump in my living expenses by buying U.S. Treasury Inflation Protected Securities (TIPS). I was right to worry about inflation – prices are 21% higher today than they were four years ago, rising by over 5% per annum – but I was wrong to buy TIPS. The value of my long-term TIPS ETF is down about 0.5% in nominal terms, and down 18% adjusted for inflation.² If that’s “inflation protection”, give it to somebody else! ³

Do TIPS offer effective protection against inflation?

TIPS are designed to protect the real spending power of your wealth over a given horizon. If the frustrated investor above had bought TIPS maturing in four years, her wealth would have much more closely tracked inflation over that period.⁴ But while that’s tempting, as we’ll see below, it’s not necessarily her best course.

It’s natural that some investors think of inflation protection strictly as ensuring their portfolio value will rise during periods of unexpectedly high inflation. If that’s truly your only goal, you should buy short-dated TIPS. However, your long-term spending power is impacted not just by inflation, but also by long-term real interest rates. $1 million of wealth goes a lot further when real interest rates are at 4% than when they’re at 0%.

If your goal is to protect long-term spending power rather than the narrower goal of protecting inflation-adjusted wealth, then longer-dated TIPS (owned directly or through ETFs) make sense and are effective. However, just as “no man can serve two masters,” TIPS cannot protect inflation-adjusted wealth in the near-term while simultaneously protecting long-term spending power.

In “Back to the Future: Reviving a 19th Century Perspective on Financial Well-Being”, we discuss why we think protecting long-term spending power is the more desirable objective – and, for readers looking for a deeper dive, we discuss a number of related issues in these two notes as well:
  How I Learned to Stop Worrying and Love the Bomb
  A Sheep in Wolf’s Clothing

Protecting Long-term Spending Power

Let’s look at an example. You have $1 million of savings you want to convert into a 25-year string of constant inflation-adjusted annual cash flows, to “lock in” your real spending power over that time. You buy a portfolio of TIPS with amounts selected so that the interest and principal payments will generate that desired series of real cash flows. To make the math super simple, let’s assume all the bonds are available at a real yield of 0%: then the $1mm you spend on the portfolio of TIPS will provide $40,000 per year of constant inflation-adjusted income.⁶

A year later, your fears of higher inflation are realized with one-year CPI running at 5%! The Fed has hiked short-term interest rates by 4%, and all the bonds you bought are now trading at a real yield of 2%. This isn’t completely fictitious, being close to what actually did happen between April 2022 and August 2023. So now you look at your brokerage statement and see that your $1mm of starting capital plus intermediate payments has turned into just $836k, for a loss in value of 16%. You might be feeling like your inflation protection let you down – but did it?

Your objective in buying this portfolio of TIPS was to create an inflation-hedged $40,000 per year of income to spend. While the present value of your portfolio is indeed lower by 16%, the cash-flow stream you created is still intact, and you’ll continue to get $40,000 per year for the next 24 years, adjusted for inflation.

This scenario is not particularly unusual, in that when inflation runs unexpectedly hot, the Fed is likely to hike short-term interest rates at a fast enough pace to eventually slow the economy and reign in inflation, which normally will lead to higher real interest rates on TIPS.

Does this make TIPS a risky investment? While the present value of the portfolio of TIPS you bought fluctuates (wildly, in this example), its long-term spending power remains constant.⁷ If you have a short horizon, buying long-term TIPS is definitely risky – but, if you think about risk with respect to your long-term spending power, long-term TIPS are relatively safe.⁸

Is it better to own TIPS via owning bonds directly or through a TIPS ETF?

The question, “Should you buy bonds or bond funds?” gets a lot of discussion in the financial press.¹⁰ We often read that it’s better to buy individual bonds rather than bond funds, as you will never suffer a loss on individual bonds as long as you hold them to maturity. We think this argument is, at best, confused.

If you want to protect against inflation or lock in a real rate of return to a specific date, then you should buy and hold individual bonds, whose maturity will naturally run down as you approach your target date. However, we think this is a relatively rare use-case. Few people, even those getting on in years, have a specific date with their name on it. Instead, many investors either have a medium-to-long and rolling horizon, or are allocating between asset classes.

In either of the latter cases where you’re trying to maintain the duration of a bond portfolio, the mechanics of holding individual bonds versus a bond ETF will be very similar. In both forms, bonds will naturally be running off, and you’ll be replacing them by buying new issues.¹¹ If the ETF is trading close to its Net Asset Value, as TIPS ETFs normally do, the returns will also be very similar between holding the ETF and a similar portfolio of individual bonds. The main difference will be that the ETF charges a management fee (0.03% in the case of SCHP), but is more convenient and likely has lower transaction costs than managing your own portfolio of individual bonds.

1. This not is not an offer or solicitation to invest. Past returns are not indicative of future performance.
   
2. Based on the largest TIPS ETF, SCHP, and including reinvested dividends.
   
3. Or, for an expression of these sentiments in the financial press, see this FT article by Toby Nangle: “TIPSplaining a lousy inflation hedge.”
   
4. In this case, she’d still have underperformed inflation by about 4% in total, since TIPS maturing in four years were trading at a real yield of -1% in mid-2020. She also could have bought and rolled shorter-dated TIPS.
   
5. TIPS at issue come with a nice but small freebee: deflation protection. The ultimate redemption value will not be less than par, even if there has been deflation over the life of the bond.
   
6. Assume all the TIPS have 0% coupons, so they’re all trading at par with a 0% real yield. Then you’re just buying $40,000 notional of 25 bonds, with maturities from one year to 25 years from present. The portfolio costs you 25 x $40,000 = $1mm, and that will provide you with an inflation-adjusted $40,000 per year.
   
7. Some readers have asked what should they have done if they strongly believed that the yield on long-term TIPS was going to increase from -1% to +2% before long, which actually did come to pass? Are we suggesting that such an investor still buy TIPS since it is the safest way for them to protect the long-term real spending power of their wealth? No, we are not. What we are suggesting is that the investor should specify the return and risk of the various other investments he can make relative to the lowest risk asset for him, which we suggest is TIPS for long-term investors. When the investor assessed each potential investment relative to the -1% yield of long-term TIPS, he may well have decided, based on his views, that rolling T-Bills or owning equities had a sufficiently high return relative to their risk versus TIPS to warrant holding those and owning no TIPS (or even shorting TIPS). Just because TIPS are the safest asset doesn’t mean the investor needed to own them.
   
8. Some readers have asked us whether it is better to roll short-dated TIPS, as this will offer the same inflation protection as owning long-term TIPS but without the interest rate risk. We think the contrary is the case for people who are concerned with protecting the long-term spending power of their wealth; rolling short-term TIPS is the strategy with interest rate risk. If you roll one-year TIPS for 10 years and real rates drop over the period, your real spending power has gone down, and vice versa if real rates rise over the period. But if you own 10-year TIPS, you are locking in a known real quantity of spending over the period, regardless of what happens with interest rates in the meantime. In this sense, not relative to your nominal wealth but relative to your spending power, it’s the one-year TIPS which give you rates exposure, while the 10-year TIPS have none. From a “balance sheet” perspective, it’s the opposite – one-year TIPS have nearly no apparent interest rate exposure, while 10-year TIPS have plenty – but for most people, we believe the spending-power perspective is more helpful than the balance-sheet perspective, since it’s maximizing the utility of lifetime spending (and bequesting) that’s the most sensible overall financial objective function.
   
9. We wish US taxation on inflation-protected bonds was the same as it is in the UK, where only the coupon income is taxed, but not the inflation-adjustment of the principal repayment at maturity.
   
10. For example, this recent article by the WSJ’s Jason Zwieg: “What to Do With Bonds When Inflation Won’t Die.”
    
11. For ETFs which sell bonds that fall outside the index, selling and replacing with longer bonds can have a tax impact, realizing capital gains or losses, but is unlikely to have a significant impact on returns as long as the ETF portfolio remains close to the target duration.