Richmond Federal Reserve President Jeffrey Lacker addressed the recent uptick in U.S. inflation in a speech last week, and said it’s likely to move back toward the central bank’s two percent target. He also specified his own GDP growth forecast of between two and two-and-a-half percent through the end of this year and next. At BlackRock, we think inflation will increase only moderately through the end of the year, though we recognize that many investors are looking to prepare their portfolios for a potential rise in prices.
In my last Blog post, I discussed how a very short duration strategy is one way for investors to hedge against the impact of rising inflation. Some investors are also seeking to hedge against rising inflation by using Treasury Inflation Protected Securities (TIPS), in the iShares TIPS Bond ETF we saw inflows of $208 million in May and $377 million in June.1 When considering TIPS as an investment it’s important to note that TIPS derive their returns from two sources – rates and inflation – and while TIPS may be a good option when hedging against rising inflation, they’re not ideal for a rising interest rate environment.
Let’s take a closer look at the mechanics. Each month the face value of a TIPS security is adjusted according to changes in the Consumer Price Index. In this way a holder of TIPS is directly impacted by changes in inflation; they will see the face value of their investment rise if inflation increases and fall if inflation declines. This is what makes TIPS unique and potentially valuable as an investment: they directly pay an investor for inflation. TIPS are a more direct inflation hedge than investments like commodities or real estate which generally have high correlations with inflation, but which are not directly tied to inflation. As a TIPS security is a bond, its price is affected by changes in interest rates. TIPS prices rise when interest rates decline, and fall when rates rise. If the increase in interest rates is driven by a spike in inflation then some or all of this price loss may be offset by the inflation adjustment.
So when do TIPS tend to do well? In environments characterized by high inflation and stable or falling interest rates. TIPS tend to struggle in rising interest rate environments, especially those that have low levels of inflation. Looking forward I believe that interest rates will gradually rise, and that inflation may pick up but isn’t likely to increase substantially in the near term. Additionally yields remain low; as a result TIPS won’t generate much income if inflation does not accelerate. For this reason my colleague Russ Koesterich and I are currently underweight TIPS. That said, they could be the right choice for an investor who is concerned that inflation may sharply increase, or who is looking to build inflation protection into their portfolio.
1Bloomberg flows data of iShares TIPS Bond ETF, May 2014 and June 2014.
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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, and does not apply to the funds.
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