What to do with a non-stock part of your portfolio? The solutions vary, but today some Treasury Inflation-Protected Securities (TIPS) offer salivating returns without any credit risk. What about duration risks? Please read on.
Briefly about TIPS
This is a short introduction for those unfamiliar with TIPS.
TIPS are government bonds currently offered in 5, 10 and 30 year maturities and, like all treasury bills, they carry no credit risk. The coupon rate is fixed at the time of issue, but the principal is adjusted according to the evolution of the consumer price index (CPI). For example, since the current CPI is 8.5%, the principal of the bond will increase by 8.5%/12~0.7% during the month. Therefore, the yield of TIPS is the sum of two numbers – its yield to maturity (YTM) today and future inflation adjustments. These adjustments are not known in advance and TIPS may yield more or less than ordinary Treasuries with the same maturity.
Given that inflation is currently high, one might think that now is the perfect time to invest in TIPS. But not all TIPS are created equal.
An investor has two main ways to invest in TIPS: either by buying individual TIPS on the secondary (or primary) market, or by buying a specialized ETF (or mutual fund). In any case, an investor must decide which maturity he prefers.
In the current macroeconomic environment, all fixed rate instruments with long maturities face significant duration risks, as their market value will decline as interest rates rise. At the same time, current yields are not high enough to compensate for these risks. For example, reliable investment-grade bonds (with a BBB credit rating) yield at best around 6% with maturities of 5 years and above. For this reason, we will only discuss short-term instruments with maturities of less than 5 years in this article.
Let’s review the yields currently offered by short-term TIPS:
In this chart, a positive YTM (Yield-To-Worst column in the chart – for non-callable bonds Yield-To-Worst is equal to YTM) should immediately catch the eye. Normally, TIPS trade at negative YTM and offer positive returns due to inflation adjustments. YTM only changed signs (for 5-year maturities) in July. YTM for regular Treasuries maturing in 1-5 years is hovering around ~3.5%. Since TIPS will return YTM plus CPI (currently at ~8.5%), they may be a superior choice not just to regular Treasuries, but perhaps to any higher quality bond.
This is particularly striking for the bond maturing on January 15, 2023 (CUSIP 912828UH1). Its YTM is around 4.4% at the time of writing and we cannot expect inflation for the next few months to be lower than, say, 5-6%. This means that this bond will return risk-free at least 9-10% annualized and even more if inflation remains at an average of 7-8% for the next four months.
Admittedly, this bond will mature in just 4 months, so all the fuss is only a few percentage points. But first, we can increase maturity at the cost of lower YTM. The bond maturing on April 15, 2023 (CUSIP 9128284H0) yields around 3%.
Secondly, to my knowledge, it is much better than any other alternative short-term fixed income option, including the banks. Please note that these bonds are highly liquid with negligible duration risk. Four months from now, regular bonds are expected to yield more than they do today, and investors can reinvest proceeds from ultra-short TIPS into higher yields.
Last but not least, these 4 months should be the period of rapidly rising rates when stocks and longer-term bonds can easily produce negative returns. It is very tempting to let this period pass (or with a reduced allocation to risky assets) while obtaining annualized returns of 9 to 10% without risk.
TVIP and STIP
There are two popular short-term TIPS ETFs sponsored by Vanguard (NASDAQ:TVIP) and Black Rock (NYSEARC:STIP). They are very convenient to trade and many retail investors use them to invest in TIPS. But convenience alone does not mean this choice is justified.
VTIP and STIP are very similar: they both hold TIPS with maturities of 0 to 5 years, benefit from negligible expense ratios and have almost equal tenors. There are minor differences between them in terms of duration (2.6 vs. 2.7 for VTIP/STIP) and expense ratio (0.04% vs. 0.03% respectively), but for practical purposes they are almost indistinguishable. For the rest of this article, we will ignore these differences and only talk about VTIP (which implies the same for STIP).
The bonds in the VTIP portfolio are replaced when they mature, leaving the duration more or less constant (it is currently 2.7 years). And that makes VTIP susceptible to interest rate risk.
Simplifying to the extreme, one can visualize VTIP as a weird single bond yielding 2.7% (that’s the YTM of VTIP today) that doesn’t change maturity over time. This maturity (and duration) remains close to 2.5 years. This means that if interest rates rise by, say, 1-2%, the price of VTIP should fall by around 2.5-5%. And this will continue to negatively affect VTIP returns as long as interest rates continue to climb, because VTIP will never mature!
Thus, VTIP should yield less than the bond maturing on January 15, 2023, because a) it has a lower YTM; b) its price is likely to fall due to rising rates. Inflation adjustments will be the same for both.
We recommend that TIPS mature on January 15, 2023 or April 15, 2023, as a superior choice of fixed income securities to replace bank deposits, VTIP/STIP and most other fixed income instruments. This recommendation assumes that interest rates will rise over the next few months.
If we are lucky enough to see lower interest rates over the next few months, longer-term bonds or reliable preferred stocks might be a better bet. But in this (unlikely) scenario, the equity portion of the portfolios should perform very well. Thus, our ultra-short TIPS promise lower correlation (compared to regular bonds) with equities in addition to better likely returns.