Fear of rising inflation does not even enter the conversation for many investors. And, it appears, rightly so. July’s consumer price index (CPI) of 1.7 fell short of consensus, extending a string of softer than expected readings and validating the market’s contention that inflation will remain around this level for the near-term. Indeed, only a few of the 39 economists that provide inflation estimates to Bloomberg’s consensus number subscribe to the Fed’s 2 percent target.
The relative cheapness of Treasury Inflation Protected Securities (TIPS), the market’s proxy for inflation, is practically shouting that the market doubts the Fed will meet its target any time soon.
But that in itself—the contrarian view—might be a reason to look at TIPS now. Unexpected inflation, the inflation the market is, by all measures, not anticipating, is exactly what TIPS protect against.
TIPS—A Quick Primer
Inflation is the rate of change in CPI. If the market is surprised by the next CPI reading, risks from unanticipated inflation increase. This risk of "surprise" inflation is potentially extremely harmful to a bond portfolio.
According to an April 2017 research note from Martin Mauro, Bank of America’s fixed-income strategist, “Unexpected inflation is the main cause of price declines for high quality bonds, and can reduce the purchasing power of both the coupon payment and principal value of a bond.” TIPS offset that risk.
“The principal value of TIPS rises with the consumer price index,” Mauro added. “The coupon rate is applied to the CPI-adjusted principal.” In other words, both the principal value and the coupon payment “rise proportionately to annual inflation.”
The notion that TIPS protect against the unexpected rise in inflation is not disputed by investors. But some people question the usefulness and attractiveness of these products versus other options.
“TIPS are underpriced relative to that forward inflation view,” says Gemma Wright-Casparius, senior portfolio manager at Vanguard. “Short-term inflation expectations are around 1.6 to 1.7 percent. The market is not anticipating inflation will reach the Fed’s target, so TIPS look a little bit cheap.”
Real assets, like commodities, and even equities shield portfolios from rising inflation as well, and with greater upside potential, so investors often pursue inflation protection there. But they protect to a lesser extent and with much higher volatility.