Some tips for investing in inflation

These government bonds pay more interest when inflation rises.

JULY 2021

Key takeaways

  • Inflation poses a threat to bondholders because rising prices reduce the purchasing power of the fixed rates of interest that their bonds pay.
  • Treasury Inflation-Protected Securities (TIPS) are bonds whose principal and interest rate payments rise along with inflation.
  • TIPS are usually more expensive than conventional bonds and they may lose value if inflation is lower than expected.
  • Investors should consider whether adding inflation protection to their diversified portfolios makes sense.

After decades when inflation has been hard to find, the prices of everything from cars to computers have jumped in recent months. Nobody knows for sure whether—or for how long—this surge in inflation might continue, but smart investors know that rising prices can make bonds with fixed interest payments less valuable. Bonds generally offer a series of fixed interest payments that represent a percentage of the face value of the bond. When inflation picks up and prices rise, the purchasing power of the interest payment decreases, meaning those fixed payments buy less stuff.

To help reduce the risk that inflation poses to bondholders, the US Treasury created Treasury Inflation-Protected Securities (TIPS) in 1997. These are bonds whose interest payments are designed to rise when inflation does. They are available in 5-year, 10-year, and 30-year maturities.

The inflation protection offered by TIPS comes at a price, though. TIPS are more expensive than conventional Treasury bonds and higher-priced bonds yield less than lower-priced bonds. For example, as of July 1, 2021, 5-year TIPS yielded −1.69% while conventional 5-year Treasury bonds paid .059%.

So why would anyone buy a Treasury bond with a lower than typical, or even negative yield? For investors who believe that inflation will rise, the answer may be that lower yields today are worth accepting in exchange for higher principal and interest payments in the future.

How TIPS adjust to inflation

TIPS yields are based on their current amount of principal. When inflation rises, the principal of TIPS adjusts higher, and the payments go up along with it. Let's look at a hypothetical example to understand how TIPS do this.

This example is for illustrative purposes only and does not represent the performance of any security. Consider your current and anticipated investment horizon when making an investment decision, as the illustration may not reflect this. The assumed rate of return used in this example is not guaranteed.

Risks of TIPS

Besides offering protection from inflation, TIPS also pose very little risk of default because they are backed by the full faith and credit of the US government. However, they do not protect bondholders from all types of risk. Indeed, if inflation gives way to deflation and the consumer price index turns negative, principal and interest rate payments on TIPS will adjust downward and investors may wish they held conventional bonds instead. It's also possible to lock in a loss in real terms if you buy a TIPS with a negative real yield and hold it to maturity. This could happen even if inflation picks up enough that the bond's nominal yield turns positive because the total return on a TIPS can never exceed the rate of inflation.

TIPS are also subject to interest rate risk, just like conventional Treasurys. That means when interest rates rise, the market value of these bonds is likely to fall. In fact, TIPS may be more sensitive to changes in interest rates than conventional Treasurys of the same maturity. Rate risk may be managed by holding individual TIPS bonds to maturity, as in a bond ladder. If you hold TIPS until they mature, you will receive either the adjusted principal or the original principal, whichever amount is greater.

Watching the breakeven rates

One way investors can determine whether TIPS or conventional Treasurys may make more sense for their portfolios is to look at what is called the breakeven inflation rate. This is the rate of inflation at which a TIPS and a conventional Treasury of the same maturity would both deliver the same inflation-adjusted return until they mature. For example, if a 5-year TIPS yielded −1.69% while a conventional 5-year Treasury bond paid 0.59% as of July 1, 2021, the breakeven for the 5-year bonds would be 2.28%. If actual inflation exceeds the breakeven rate in the future, the adjustment to the TIPS will eventually provide a higher real return than the conventional bond. However, if inflation comes in lower than the breakeven rate, the conventional bond will provide a better return.