I find it interesting that, as important and liquid as the inflation-linked bond market is, the tactical allocation between TIPS and nominal bonds is, at best, an afterthought for most investors.
Perhaps this is because TIPS (if you think in a nominal space like most investors do) can be extravagant and complex to analyze bond by bond.
Here is a picture of the TIPS yield curve. The red line is how actual TIPS returns are calculated and therefore the curve as perceived by the market.
The green line is the true yield curve, adjusting for how the seasonality of inflation affects each individual bond.
It’s understandable, but I don’t think it’s enough. Most investors do not invest in individual bonds, especially in the TIPS space.
They invest through mutual funds or ETFs, although “staggering” TIPS to form a crude inflation-linked annuity is a popular approach among do-it-yourselfers.
Then why so many investors own nominal bonds, rather than inflation-linked bonds, as an immutable strategic allocation?
Even those who make occasional tactical shifts toward TIPS appear to do so when they expect inflation to rise and are therefore making a macro decision rather than a quantitative decision.
But there are many times when owning TIPS instead of nominal bonds is simply a good bet, regardless of your immediate view on inflation.
The most obvious one I wrote about in March 2020 was “.”
I’ve also written generally about why you might want to hold long positions in inflation-linked bonds, even if the current level of breakeven inflation (aka “breakeven”) is about right based on your view of the path of inflation .
(See “” as an example).
But the times when it is advantageous to simply be long TIPS rather than nominal or be long breakevens or inflation swaps if done as a leveraged play are not limited to unusual circumstances.
TIPS have also tended to be consistently cheap over long periods, which .
Another way to look at the same question is to ask, “If you had bought 10-year breakevens when they were at a particular level, how would you have done historically?”
Equivalently, “if you had switched to 10-year TIPS, instead of , when the spread was at a particular level, how much would you have outperformed or underperformed it historically?” The following chart answers that question.
I went back to February 1998. For each of the 6453 days (which ended in June 2023, since I had to wait 6 months forward), I considered the initial 10-year breakeven rate and calculated the return on being long that equilibrium point during the next 6 months. .
That return depends on the relative returns of different securities, how those returns (and therefore the break-even point) changed over time, and how actual inflation developed.
It is worth noting that in this period core inflation was below 3% for 90% of the time. Ergo, one would not expect to have many big wins due to the inflation surprise, although of course towards the end of the historical period it was.
The graph shows for each category (I placed the 58 days with 10-year breakeven points less than 0.75% in the same category, which turned out to be equal to the number of days in the 2.75%-3.00% category) what is the average 6 Multi-month performance became a 10-year long breakeven point along with the 10th percentile and the 90th percentile.
So you can see that on averageno money was lost with long breakevens below 2.50%, even though inflation during this period was very low.
That’s a function of what I said earlier, that TIPS were generally cheap during this period. And if you bought breakevens (or switched to TIPS) any time the breakeven was below 1.5%, you had a 90% or better chance of winning.
Naturally, it should come as no surprise that if you buy breakeven securities at a cheap level (as with any asset) you have a better chance of winning than if you bought it at an expensive level.
What’s a little more surprising is that historically there hasn’t been much pain, on average, from having long balance points even when they are high. In fact, unless you bought breakevens above 2.75% (basically an event in 2022), you had at least a 40% chance of winning your bet (10-year TIPS outperform).
This is not to say that there are not many ways to lose, trade or invest in TIPS.
Like any other investment, they can lose money and in 2022-2023 being naked in TIPS was almost as painful as being naked in any other fixed income instrument.
Almost. You did it lots Better than if you had owned nominal Treasuries during the same episode!
I used the Bloomberg US 10-year Breakeven Inflation Index, which is a total return index (BXIIUB10 Index on Bloomberg), since its inception in 2006; Before that, I used calculations from Enduring Investments that used roughly the same methodology.