Treasury Ination-Protected Securities (TIPS):

A primer on ination-linked bonds and their relative value as an ination hedge

Body Text Bold: Treasury Inflation-Protected Securities (TIPS) have a relatively unique profile within fixed-income portfolios, which has important Body Text: 9/12 Black aecenas orci ante, ultricies quis fermentum id, implications for investor objective setting and portfolio construction. This article explores the different motivations for using condimentum a lectus. Quisque vel magna diam, vitae tempor elit. TIPS and other inflation hedges within a broader investment portfolio. Vestibulum ante ipsum primis in faucibus orci luctus et ultrices cubilia.

While the focus of this piece is on the U.S. market, several other countries, both developed and emerging, issue inflation-protected securities, or linkers, that provide diversification benefits to an inflationlinked portfolio. However, on a global basis, the characteristics of inflation-linked securities may vary from one market to the next.

TIPS Versus Nominal U.S. Treasury Bonds

The U.S. Treasury began issuing Treasury InflationProtected Securities (TIPS) in 1997. From 1997 to 2010, the U.S. market grew to approximately $600 billion in outstanding debt, roughly 40% of the global inflation-linked market.* The Treasury auctions five-year, 10-year and 30-year TIPS (as recently as 2009, there was also a 20-year TIPS) that pay coupon payments semiannually. The securitys coupon is a fixed rate determined at auction. The coupon is applied to an inflation-adjusted principal dependent upon the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) with a three-month lag. The inflation-adjusted principal is then paid out at maturity. To explain the TIPS market, we compare the structure of TIPS to a nominal U.S. Treasury. As a first step, we look at a 10-year nominal U.S. Treasury with a 3.5% coupon. If an investor purchased $1,000 par of that bond, he would receive a semiannual coupon payment of 1.75% (3.5%/2) on the $1,000 principal, or $17.50. At maturity, he would also receive the entire $1,000 in principal. This stream of interest and principal cash flows is fixed over the life of the bond for a buy-and-hold investor, regardless of changes in inflation. By contrast, a 10-year U.S. TIPS pays a coupon of 1.3%. If an investor purchased $1,000 par of the new 10-year TIPS on that date, the owner would receive semiannual coupon payments with an interest rate of 0.65% (1.3%/2) over the life of the bond. However, unlike the nominal Treasury, the amount of the coupon payment is not known at the time of purchase because the principal amount changes as a result of realized inflation. For example, if, over the first year of the TIPS, lifetime inflation was 5%, the index ratio for the inflation-protected security would be 1.05, and the new par amount one year from now would be 1,050 (1,000*1.05). The owner of the TIPS in one year would receive a coupon payment of $6.83 (0.65% x 1,050). At maturity, the owner of the TIPS would receive the principal back from the government based on the cumulative total inflation that occurred over the 10 years the bond was outstanding.

Importantly, the principal amount can increase or decrease depending on inflation or deflation (i.e., a coupon can be calculated on a value greater than or less than par value). However, the principal paid at maturity will not fall below par value ($1,000 in our previous example). This principal protection that TIPS provide can also be thought of as a deflation put, or deflation floor. Due to the deflation floor, when there are persistent deflation fears in the marketplace, newissue TIPS with an index ratio closer to par will perform better than more seasoned TIPS with higher index ratios. Put another way, in a deflationary environment, the deflation floor that TIPS provide at par is much closer to being in the money for a new issue than it is for a more seasoned inflation-linked bond.

While the focus of this piece is on the U.S. market, several other countries, both developed and emerging, issue ination-protected securities, or linkers, that provide diversication benets to an ination-linked portfolio. However, on a global basis, the characteristics of ination-linked securities may vary from one market to the next.
It should be noted that the yield to maturity of a TIPS can also be considered a real yield. In other words, the real yield is the yield earned over the next 10 years that the investor can lock in today, over and above the level of inflation. The difference in yield between the nominal 10-year Treasury and the 10-year TIPS is called an inflation breakeven. The spread between the two securities is equal to the approximate annualized inflation rate over the next 10 years for an investor to be indifferent between buying and holding until maturity the nominal Treasury and the TIPS. Thus, when investors expect inflation to be higher than the breakeven rate, they prefer TIPS over nominal bonds. The opposite is true when an investors inflation expectation is lower than the prevailing breakeven rate.

*Martin Hegarty, BlackRock Inflation-Linked Portfolio Manager

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Based on our experience, making assertions about the relative share of each factor (technical and fundamental) to explain the performance of TIPS relative to nominal Treasuries can be notoriously difficult and highly dependent on assumptions.
Nominal Treasury Bonds and Real Duration
Irving Fishers renowned theory on interest rates points out that the interest rate earned for holding a nominal bond can be broken down into two components: a real interest rate and compensation for expected inflation. As such, all nominal bonds, Treasuries, corporates, agencies, etc., are sensitive to changes in both real interest rates and in inflation expectations. Nominal duration, the measure that is most often used in fixed income (generally just called duration), quantifies a bonds sensitivity to a change in the nominal interest rate. When investors own a TIPS portfolio, they receive that same real interest rate but are hedged against inflation. As a result, they are not sensitive to changes in inflation expectations. Since this has important implications in terms of duration, it led to the development of an alternative duration measure for TIPS, called real duration. Real duration measures the change in TIPS as a result of the change in real interest rates. While real duration is an important risk metric for TIPS, it does not easily lend itself to comparison to nominal bonds, which use duration based on nominal interest rates. Technically, every nominal duration figure can be broken down into real duration and duration based on inflation expectations. However, from a practical standpoint, since it is easier to take TIPS real duration and adjust them back to nominal terms, that has become a standard market practice. As you move out on the TIPS curve, those transitory effects become less relevant. While other factors can still influence pricing, the intermediate to long end of the TIPS real yield and breakeven curves can be viewed as the markets vote on the effectiveness of monetary policy. In a speech on April 15, 2004, current U.S. Federal Reserve Chairman Ben Bernanke said, Although clues about inflation expectations abound in financial markets, inflation-indexed securities would appear to be the most direct source of information about inflation expectations and real interest rates.*

How TIPS Performed During the Credit Crisis

Similar to most other market sectors, 2008 was an especially volatile year for TIPS. The year began with a bubble in oil and commodities, which caused breakevens, especially on the front end of the curve, to widen out. In July, the commodities bubble burst and that, coupled with the infamous Lehman bankruptcy and the massive deleveraging that followed, pushed breakevens to negative territory all the way out to the 10-year part of the curve. As mentioned earlier, the breakeven spread can be viewed as the approximate breakeven inflation rate for holding a TIPS versus a nominal Treasury bond until maturity. However, if an investor sells out of their position before maturity, there are many factors that can drive the breakeven rate. As a result, there may be more than just an inflation/disinflation view expressed. For instance, the relative value of nominal Treasuries is adversely affected by an increase in the inflation risk premium or the risk associated with increased inflation volatility. Conversely, nominal Treasuries do have a liquidity premium that makes them more attractive because of their market preference during flight-toquality episodes. Liquidity premium was an especially prevalent issue in late 2008 and early 2009. During the crisis, investors around the globe had a strong preference for on-the-run nominal Treasuries since they were viewed as the ultimate safe-harbor investment in the worlds reserve currency. The market consensus is that this flight to safety was the largest factor in TIPS

TIPS and Monetary Policy

As mentioned previously, the index that TIPS utilize is the CPI-U, which includes food and energy but is not seasonally adjusted. The CPI-U is a much more volatile index than the preferred inflation measure of the Federal Reserve, core CPI, which excludes food and energy. As such, the performance of the front end of the TIPS curve is driven by the carry received based upon the CPI-U. Therefore, breakevens on the front end are highly correlated with energy prices and seasonal inflation effects.

*Remarks by Governor Ben S. Bernanke before The Investment Analysts Society of Chicago, Chicago, Illinois, April 15, 2004. http://www.federalreserve.gov/boarddocs/speeches/2004/20040415/default.htm
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underperformance relative to nominal bonds in 2008. However, the massive flight to quality that so negatively impacted TIPS breakeven spreads was compounded by the economic reality of 2008 heightened deflation fears that resulted from the shock of the credit crisis on the economy. Overall, what happened during 2008 was a great example of how TIPS breakevens can be driven by both technical factors, such as liquidity, and by fundamental factors, such as deflationary fears. Based on our experience, making assertions about the relative share of each factor (technical and fundamental) to explain the performance of TIPS relative to nominal Treasuries can be notoriously difficult and highly dependent on assumptions. Importantly, while TIPS did perform poorly during 2008, on an absolute basis, they outperformed several other components of the fixed-income market. During 2009, the TIPS market outperformed Treasuries as they continued their path toward normalization (Figure 1).

of TIPS are state and local governments. The reason? State and local government pensions are more likely to have liabilities with a price indexation relative to their private pension counterparts.** TIPS portfolios are also fairly prevalent in defined contribution plans. In particular, a growing majority of target-date funds have utilized TIPS and other real return assets to provide a measure of inflation protection. While most target-date managers have some exposure to TIPS, there is not a clear consensus about when to introduce the asset class on the glidepath. Modeling Towers Watson has conducted indicates that TIPS can provide long-term inflation protection for target-date strategies, and the asset class provides the most benefit when it is implemented closer to retirement.

Reasons for Holding TIPS

Various Treasury publications have shown that, when compared to nominal Treasuries, TIPS have a smaller share of competitive auction awards going to primary dealers and foreign categories, and more going to investment funds and other.* Nominal Treasuries, which are more liquid and seen as a safe harbor during market turbulence, garner more demand from foreign central banks and Wall Street trading desks. While both groups are active in the new-issue TIPS market, domestic end users, such as mutual funds and pension funds, make up a larger proportion of the new-issue process. TIPS play an important risk management role for some investors, particularly U.S. pension plan sponsors with inflation-linked liabilities. According to a recent analysis by Barclays, the largest pension fund holders

Modeling Towers Watson has conducted indicates that TIPS can provide long-term ination protection for target-date strategies, and the asset class provides the most benet when it is implemented closer to retirement.
For other investors seeking diversified sources of incremental return, TIPS provide a straightforward way to express a view on inflation relative to prevailing breakevens. Ultimately, TIPS are added to investment portfolios for several reasons, including tactical positions driven by views on breakeven rates or real yields, a general strategic allocation for diversification purposes or an inflation hedge. As a result, it comes as little surprise that Barclays contends that the largest holders of TIPS are core, core plus and total return portfolios, as well as other mutual funds.**

Figure 1. Barclays Capital xed-income index returns in 2008 and 2009

Q108 U.S. TIPS U.S. Treasury U.S. Corporate Investment Grade U.S. Corporate High Yield U.S. MBS ABS CMBS
Source: Barclays Capital Live

Q208 -0.3 -2.1 -0.7 1.8 -0.5 -0.8 0.2

Q308 -3.5 2.3 -7.8 -8.9 1.9 -3.7 -5.8

Q408 -3.5 8.8 4.0 -17.9 4.3 -6.8 -13.5

2008 -2.4 13.7 -4.9 -26.2 8.3 -12.7 -20.5

Q109 5.5 -1.3 -1.9 6.0 2.2 7.6 -1.9

Q209 0.7 -3.0 10.4 23.1 0.7 7.6 12.5

Q309 3.1 2.1 8.1 14.2 2.3 6.3 12.7

Q409 1.8 -1.3 1.3 6.2 0.6 1.3 3.3

2009 11.4 -3.6 18.7 58.2 5.9 24.7 28.5

5.2 4.4 -0.2 -3.0 2.4 -1.9 -2.6

* A TIPS scorecard: Are They Accomplishing Their Objectives? Financial Analyst Journal, Volume 66, Number 5 ** Barclays Capital. Global Ination-Linked Guide, March 15, 2010
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TIPS do provide diversification, but they are not as strong a diversifier relative to credit as most tend to think. From a historical perspective, during flight-toquality periods, nominal Treasuries have outperformed every asset class including TIPS. At the opposite end of the spectrum, during times when risk aversion wanes and the market view on the economy improves, TIPS and virtually every other credit sector outperform Treasuries since an improving economy also means increased inflation potential.

provide an effective hedge against inflation. As the performance of the housing market from 2008 to 2010 or the stock market during the 1970s has shown, those correlations do not always hold up under every inflation scenario, and those asset classes had their own substantial set of risks. It is true that the TIPS real rate duration risk can limit the effectiveness of the inflation hedge TIPS provide. However, inflation-linked assets are the only assets that have an explicit relationship with inflation. As a result, these assets should provide a measure of protection against inflation over a greater number of economic scenarios. Of course, an effective hedge against inflation does not have to be an all-or-nothing TIPS proposition. That is why many managers offer real return products. In a real return fund, an effective manager should be able to utilize commodities, TIPS and other assets in a portfolio to outperform CPI. We continue to see more life-cycle managers consider the use of other inflation-protection options, such as commodities and real return funds, in their plans. While real return funds are not included in the scope of this paper, there are a couple of points worth considering when looking at this type of investment. First, a real return manager has a significant amount of discretion to invest in a variety of assets. But not all managers are up to this task. Only a manager with very strong macroeconomic research capabilities should be considered for this job. Second, that discretion to seek out real return might imply a considerable variation in allocation across various assets within the fund over a time. Having a significant allocation to such a fund could, in turn, cause unintended volatility to a pension funds broader asset allocation mix. Inflation derivatives are another option when constructing an inflation hedge. Recent academic research has shown that TIPS have historically been underpriced relative to a synthetic TIPS portfolio of nominal Treasuries and inflation swaps.** Beyond costs, these are also very complex markets with different risks and liquidity features than the cash/ physical market. While there are some managers who are capable of handling such a mandate, because of cost, liquidity and counterparty risk, inflation derivatives are likely to be most suitable for clients who have an explicit inflation-linked liability they want to immunize in a highly customized manner.

Inflation Hedging
Unlike other fixed-income indices, historical data illustrate TIPS positive correlation with inflation. This correlation is lowered by the fact that the Barclays TIPS index has a real duration of approximately eight years.* Along with an inflation hedge, a TIPS portfolio has considerable real rate duration risk, as an investor is only truly inflation hedged if his time horizon is identical to the maturity of the TIPS. If an investor must sell his inflation-linked bond early, then he is exposed to real rate risk and the risk associated with changes in various risk premiums.

We continue to see more lifecycle managers consider the use of other ination protection options, such as commodities and real return funds in their plans.
Historically, oil and the broader commodity index have had a higher correlation with inflation than TIPS. Given how heavily food and energy are part of the CPI-U, this close relationship is not surprising. However, the CPI is based on a basket of goods, and there is no guarantee that future inflation will be driven by or result in higher commodity prices. For instance, a future increase in the CPI could be the result of higher medical costs because of demographic shifts in society. Generally speaking, there is a high correlation between inflation and commodities. In many market scenarios, commodities can be a very effective hedge. In the past, equities and real estate were also thought to

* Source: Barclays ** Why Does The Treasury Issue TIPS? The TIPSTreasury Bond Puzzle, Matthias Fleckenstein, Francis A. Longstaff, Hanno Lustig September 2010
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Performance of TIPS in Various Scenarios

TIPS, along with other asset classes, may perform better or worse in various economic scenarios. Figure 2 illustrates the tendencies of stocks, commodities, nominal bonds and TIPS across four scenarios. The key to TIPS performance comes down to the movement in real yields and the actual inflation accruals received. In a stagflation scenario (bottom right), TIPS will benefit from falling real yields and high inflation. In a more benign inflation environment where the economy is improving but inflation is limited, TIPS will have their worst performance (top left) because real yields are moving higher without a sufficient offset from the inflation accrual received. In the other two categories in this table (top right and bottom left), one of the return drivers is a positive and the other is a negative, which is why TIPS returns will be mixed.

Figure 2. TIPS and other assets in various economic scenarios

Secular Shift

High/Rising

Best:

Stocks

Best:

Commodities

Mixed: Commodities and nominal bonds Worst: TIPS Best: Nominal bonds

Mixed: Stocks and TIPS Worst: Nominal bonds Best: TIPS

Real Growth

Low/Falling

Mixed: Stocks and TIPS Worst: Commodities Low/Falling

Mixed: Commodities and nominal bonds Worst: Stocks High/Rising Ination

Source: PIMCO Institute, Presentation on An Introduction to Inflation-Related Investing by Bob Greer, September 24, 2010

Conclusion
As Figure 2 clearly illustrates, there are times when TIPS will perform better than other investments. However, for a long-term investor, TIPS can provide an inflation hedge and some diversification benefits to a portfolio. For investors looking for an inflation hedge, Towers Watson believes in a long-term strategic allocation to TIPS. At the same time, we realize it can be difficult to determine when to enter the TIPS market. It may also be hard to justify choosing TIPS versus nominal Treasuries, since TIPS can be expensive in certain markets. For all of these reasons, we recommend that clients looking to select the most appropriate asset class for their unique situation should seek the advice of their Towers Watson consultant. Disclaimer: The information contained in this article does not constitute legal, accounting, tax, consulting or other professional advice. Before making any decision or taking any action relating to the issues addressed in this article, please engage a qualied professional advisor.

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