Discussing inflation may be getting a little redundant, I know, but it continues to be front and center for both consumers and investors alike. The Labor Department released inflation data for May, which ticked up by 1% for the month and 8.6% over the last year. This is the highest it’s been in roughly 40 years.
Big drivers for the month were energy, up 34.6%, and groceries, up 11.9% over the last year. That is the biggest jump since 1979. Airlines and hotels also saw big increases of 37.8% and 19.3% as people looked to travel, perhaps for the first time in two years.
Therefore, after a bit of a reprieve in April when inflation bumped up by 0.3% for the month, the smallest increase for the year, May’s data shattered any hopes of inflation beginning to subside.
The Ripple Effect
The implication from all this inflation data was the expectation the Fed would need to be more aggressive in their fight to control inflation. They took a step to do that when they raised the Federal Funds rate by 0.75%, and laid out plans to continue raising rates this year and next. From a market standpoint, prices declined in both equity and fixed income markets.
Consequently, with high levels of inflation, some investors were caught by surprise to find out that their Treasury Inflation Protected Securities (TIPS) are down for 2022. Now, as a category, TIPS, are down over 8% as of June 17. However, this is slightly better than the Barclays Aggregate Bond Index, which is down 11.5%, but with the highest inflation in 40 years, some people may have expected these bonds would be thriving. The question is: Why aren’t they?
Let’s take a look at what these investments really are and how they work. TIPS are U.S. Treasury securities whose principal is indexed to inflation. When inflation increases, the principal goes up. When inflation decreases, the principal goes down. Since they are U.S. Treasury securities, the risk of default is extremely low. The U.S. government currently issues TIPS in 5, 10- and 30-year maturities.
When a TIPS bond matures, the owner receives an adjusted principal accounting for inflation, or the original principal, whichever is greater at the time. Each bond also has a fixed coupon rate and pays coupon payments every six months. Since the bond’s principal is adjusted to reflect the change in inflation or deflation, the bondholder can receive coupon payments that vary.
How Coupon Payments Work
Let’s assume you invest $10,000 in a TIPS bond that has a fixed coupon of 2%. With no inflation over the first six months, you would receive a coupon payment of $100. This is 2% applied to $10,000 and divided by 2, since it is for half of the year.
If inflation increases by 3% over the next six months, your principal would increase by 3% to $10,300. Your coupon payment would then be calculated on the new principal amount. In this case, 2% on $10,300 generates a $206 annual payment – but again, since this is just for six months – so we need to divide that by 2 to get the payment you would receive, which is $103.
An important point to understand is that inflation data is used to adjust the principal. All TIPS owners should be aware that the IRS considers the increase in TIPS’ principal, due to inflation, to be taxable income in the year it occurs.
TIPS are adjusted using the non-seasonally adjusted Consumer Price Index (CPI). This is different from the seasonally adjusted CPI typically referenced by the media. Certain prices can vary quite a bit during different seasons. Food and energy are probably the two prime examples of this. So, while you may hear inflation was up 0.6% for the last month, this may be the “seasonally adjusted” figure. Non-seasonally adjusted CPI may have increased by 0.4%.
In addition, the inflation adjustment to TIPS has a three-month lag. Therefore, TIPS owners have a delay in principal adjustment and in the coupon payment.
These Are Bond Investments
Being bond investments with fixed coupons, they are impacted by changes in interest rates. The duration is the measurement of a bond’s price sensitivity to changes in interest rates. A bond or bond fund with a duration of 7 would indicate how much the bond would move up or down if interest rates change by 1% either higher or lower. In this case, higher would result in a 7% decline.
The change in interest rates can have a bigger impact on the performance of TIPS than the change in inflation. For the past 20 years this has been true for TIPS with durations over 5 years.
For those investors that own inflation-protected or inflation-linked bond funds, like the Vanguard Inflation-Protected Securities, or American Funds’ Inflation-Linked Bond, you may be surprised that they are both down close to 6% for the year. But when you consider both have durations over 6, and the impact that interest rates have, perhaps it may not come as much of a surprise.
The last note on TIPS is that since they trade on the open market, investors will compare these bonds with a traditional treasury bond with similar features. Given TIPS have an inflation adjustment feature, investors will factor in what they expect inflation to be over the time of the bond. This plays a role in the price of the bond.
If inflation comes in line with what the market expects, the after-inflation yield would be similar between TIPS and a conventional Treasury. Where TIPS can excel, versus an ordinary Treasury bond, is when inflation exceeds expectations, causing the principal to increase more than what the market has priced in. So, as you can see, there are a lot of factors that can influence the performance of TIPS.