Occam’s – Can TIPS Help You?

Inflation is one of the most serious risks that retirees face. While there are a lot of ways to mitigate inflation risk, TIPS, or Treasury Inflation Protected Securities, are one of the few investment options that directly hedge against inflation risk. They aren’t perfect, and there are certainly some things to consider when you use them in a portfolio, but they are an incredibly useful tool at your disposal. Before we start thinking about if they are appropriate for you and your situation, let’s talk about what exactly TIPS are, how they work, and why one would want to use them.

What are TIPS?

As you might surmise from the name, TIPS are securities issued by the US Treasury that try and protect you from inflation. More specifically, these are bonds that are indexed to the US City Average All Items Consumer Price Index for all Urban Consumers (in other words, the general broad based inflation rate, and what most people mean when they say CPI or inflation). TIPS pay a fixed interest rate, and account for inflation by adjusting the actual principal amount of the bond. When there is inflation, the principal of the bond will adjust up, and if we have deflation the principal will be reduced. This adjustment can have some pretty serious tax consequences, but we’ll touch on those later. So, what we have is a very secure bond with little to no credit risk (it’s backed by the full faith and credit of the US government, so bad things have to happen for them to default), that will reliably track inflation…But aside from it being really cool to finance geeks, why would you want to use TIPS?

The simple answer is to protect yourself from inflation risk. As mentioned earlier, inflation is one of the main risks that retirees need to deal with, and TIPS deal with this risk directly. However, like everything, there are both alternative solutions and tradeoffs to consider.

Earlier, I mentioned that there are tax consequences associated with TIPS’ inflation adjustment. This principal adjustment is considered income for tax purposes, so TIPS tend to carry a higher tax bill than other Treasury bonds (and bonds are not noted for their tax efficiency to begin with). This makes asset location even more important than with a traditional bond. Not only could you potentially have a higher tax burden, but you don’t even have that money in your pocket; it’s not actually distributed until maturity. This is often referred to as “phantom income”. It’s not a stretch to call TIPS the most tax inefficient commonly used asset class.

You also need to consider what this inflation protection actually costs. The market doesn’t give you anything for free. You’re offloading inflation risk, but it still exists; someone else is just holding it for you, and they want to be compensated for that. This is something that we can observe pretty directly. The cost of the inflation protection is the difference between the TIPS yield and the yield of a comparable Treasury bond without inflation protection. The question you need to answer is if that price makes sense to you.

Just like municipal bonds, the investors most in need of protection are going to want to hold TIPS, so they will be bidding these bonds up. These are the people who are willing to pay the most for the protection offered. Since most investors focused on retirement are more exposed to inflation than the average investor, there’s a good chance that TIPS will make a lot of sense for these financial plans.

However, it is important to remember that the inflation rate that TIPS use to make adjustments won’t track with the inflation rate experienced by the average retiree. One of the biggest differences between the broad based CPI used by TIPS and what retirees face is the relative importance of healthcare costs. It’s not just that health care inflation tends to be a lot higher than the general CPI; the two numbers aren’t even all that well correlated. From 1947 through 2018, there was only a 0.28 correlation between the Treasury Department’s measure of healthcare inflation and the broader inflation rate(1). This being said, TIPS will roughly track the bulk of a retirees spending.

How Else Can You Protect Yourself From Inflation?

As wonderful as TIPS are, they aren’t the only game in town to mitigate your inflation risk. To get them out of the way, commodities are often presented as a way to hedge inflation risk. Putting it mildly, this is a bad idea[https://retirementresearcher.com/terrible-way-protect-retiree-inflation/]. The long-term returns of commodities may approximate inflation, but they bounce around like stocks, and that volatility often presents itself at exactly the wrong times (2).

With commodities dealt with, we can look at other more effective options. First up, there are other inflation protection products out there – most notably annuities with inflation riders. Just like everything else in the annuity world, there are all sorts of options and permutations on this, so it’s hard to speak definitively positively or negatively on these. However, inflation protection from annuities tends to be relatively expensive. You’re asking the insurance company to take on the inflation risk for you, and they definitely want to be compensated for that. And more than that, people have shown that they are happy to pay to offload inflation risk, so insurance companies are happy to charge for it.

There are also other inflation protected bonds floating around out there. Most notably, there are inflation protected bonds issued by a number of non-US governments. These also come with a number of issues: foreign governments often have higher credit risk than the US Treasury, you have to deal with foreign exchange risk since they are not denominated in US Dollars, and these bonds are not hedging against the US inflation rate, so the inflation rate being hedged may be significantly different than the one that you experience. There’s also nothing to stop a company from issuing an inflation protected bond, though this has proven to be pretty unusual in practice.

There are two investment options that can help protect you from inflation that I want to consider in more detail, especially since you likely already have them in your portfolio: short term bonds and stocks.

All nominal bonds (otherwise known as “regular” bonds – bonds that don’t adjust with inflation) have implicit inflation assumptions baked in through their prices. If you think that inflation will be high going forward, you’ll demand a higher yield for holding a given bond (simply put, you’ll be willing to pay less to buy that bond). If you think that inflation will be lower going forward, you’ll be willing to accept a lower yield. This is true no matter the maturity of any particular bond. What makes short term bonds valuable for inflation protection is that the bonds you are holding in a short-term bond portfolio are constantly changing (3). Rolling through your bonds like this means you are constantly brining in the market’s new expectations about inflation (along with a whole bunch of other stuff muddying the waters.) The same thing could theoretically be done with longer term bonds, but trading longer term bonds typically costs a lot more than it does for short term bonds, and people tend to hold onto longer term bonds.

The big issue with using nominal bonds for inflation protection is that it can’t protect you from inflation shocks. If something were to happen unexpectedly, you would essentially eat that jump in inflation above what was priced into the bonds when you bought them. This is a crucial point: even if you have been buying bonds regularly, and the bonds you have purchased recently all priced in the likelihood that there would be an inflation spike, your experience with a bond is based on the price you actually paid for that bond.

The other common tool to protect against inflation is stocks. It’s important to note though that the logic is flipped on its head. With a stock you aren’t buying a static set of cash flows. You’re buying a claim on the cash flows of a company that is constantly adjusting to economic conditions. Just like with bonds, the inflation protection is baked into stocks through their price (along with everything else that you can imagine). In other words, to the extent that a shift in inflation rates wasn’t expected, we would expect to see it reflected after the fact (and very quickly after the fact).

Well, we can quantify this, as well as how inflation surprises affect stock returns.

We’re interested in looking at periods where inflation jumped (either up or down) moderately to significantly. These are the periods where the market would be less likely to be able to “predict” the changes and adjust prices accordingly. From 1926 through 2018, there were 145 times where inflation increased by more than 0.5% from one month to the next, which represented about 13% of the total months in the period.

In other words, we would expect to see a jump a little more than one and a half times per year. While it’s interesting to see how much the inflation rate jumps around, what we are curious about is how the stock market acts when inflation is moving around. So, let’s look at the relevant returns of the S&P 500 Index.

	Average Monthly Return of the S&P 500 Index	Monthly Standard Deviation of the S&P 500 Index	Probability that Average Return is Different from Total Period (4)
Total Period (1926 – 2018)	0.94%	5.38%
Months with Inflation Jump	1.88%	7.63%	85%

Data from 1926 – 2018. An inflation jump is defined as the rate of change of the US CPI increasing more than 0.5% from one month to the next. For illustration purposes only. Indices not available for direct investment. S&P 500 data from Yahoo Finance. US CPI Data from the Federal Reserve.

There are a few things that should immediately jump out at you from this data. First, the average return in months when inflation jumped up is twice the average monthly return over the total period. On the other hand, there was more volatility when we had an inflation jump. But is this a real effect, or is it just random noise in the data? Well, typically when we are examining relationships in financial data (along with most other statistical analyses) we want to be 95% sure that the relationship isn’t the result of noise. This result doesn’t quite rise to that level of significance, but it’s certainly waving us over and saying that there might be something interesting to look at a little more deeply.

The immediate question that should follow is what happens in the subsequent months. Do stock returns increase in the months following a jump in inflation to “correct” for inflation?

Well, not really.

	Average Monthly Return of the S&P 500 Index	Monthly Standard Deviation of the S&P 500 Index	Probability that Average Return is Different from Total Period (5)
Total Period	0.94%	5.38%
Months with Inflation Jump	1.88%	7.63%	85%
Inflation Jump +1 Month	0.96%	8.07%	2%
Inflation Jump +2 Months	0.84%	7.48%	12%
Inflation Jump +3 Months	0.84%	6.64%	14%

Data from 1926 – 2018. An inflation jump is defined as the rate of change of the US CPI increasing more than 0.5% from one month to the next. For illustration purposes only. Indices not available for direct investment. S&P 500 data from Yahoo Finance. US CPI Data from the Federal Reserve.

When we add a lag, the numbers drop pretty drastically. With a one month lag, the average returns look pretty similar to the total period, though there is a noted increase in the volatility. When we push out a little bit further, the average returns for the two and three month lags is actually a bit lower than the average returns for the total period. Overall, there’s no particular reason to believe that these inflation jumps are having any impact on stock returns past the month that they occur in.

This is what we expect to happen. The markets price in expectations of future inflation, but can’t price in unexpected inflation, and have to adjust on the fly. It is worth noting that this is very noisy inflation protection at best, even ignoring that different stocks will react differently to inflation. It definitely doesn’t rise to the level of TIPS in terms of mitigating inflation risk.

So How Should You Use TIPS?

If TIPS make sense for you, how should you actually use them? How do they fit into your retirement income plan? There are two primary approaches that you can use. You can either buy individual TIPS, or you can buy a TIPS fund.

If you are looking for reliable income that will keep pace with inflation, want to immunize specific future cash flows, or want to use TIPS as part of a flooring strategy, then you will likely want to purchase individual TIPS and hold them to maturity. If you will hold TIPS as part of your broader diversified portfolio, you’ll likely want to use a TIPS fund. From an economic standpoint, holding a portfolio of individual TIPS is pretty much the same thing as holding a fund that owns those same TIPS. The difference is how they are managed through time.

If you are going to hold the bond to maturity (like you would if you want to be sure to get specific cash flows), then you will want to own the individual bonds directly. On the other hand, if your TIPS allocation is part of your diversified portfolio, then you are likely not as concerned with the specific cash flows, and more concerned about the level of term risk you are taking on from your TIPS. Trying to maintain a relatively consistent maturity or duration with individual bonds can be a tall order, but this is where funds shine. They have the scale to do this much more efficiently than you or I could do on our own, plus it saves you a pretty big headache with the day to day management of the portfolio.

As we discussed earlier, we do need to watch out for the tax consequences of TIPS. Because of the inflation adjustment, TIPS are one of the least tax efficient asset classes out there. Bonds in general are already at the front of the line to get into your tax advantaged accounts, but TIPS should probably be one of the first things you place in these accounts.

As a group, retirees are more exposed to inflation risk than the average investor, and TIPS are one of the most powerful tools that retirees have to mitigate their exposure to inflation risk. There are certainly things that you need to consider when thinking about whether TIPS are a good fit for your portfolio, but they are a great option for most retirement focused investors.

1. Health care inflation rate measured by the Consumer Price Index for All Urban Consumers: Medical Care Index, Not Seasonally Adjusted. 1947 was the first full year that data is available. Data from the Federal Reserve Economic Data.
2. As you may have noticed, commodities are one of my personal hobby horses. What gets people excited about them is usually precisely the reason they aren’t a good fit for most retirement investors[https://retirementresearcher.com/should-your-portfolio-include-commodities/].
3. Say you have a portfolio of bonds that mature in one year. You’re guaranteed to have a portfolio turnover of at least 100%, since even if you do nothing, all of the bonds will mature, and leave the portfolio, in a year. If you are trying to keep the portfolio’s maturity or duration at roughly a specific point your turnover is likely to be even higher. The tighter leash you keep on your maturity, the higher your turnover will be.
4. Calculated as one minus the computed P Value.
5. Calculated as one minus the computed P Value.