Here’s a tip: look to TIPS as a fixed income alternative

Jeff Rosenberg talks about why investors should consider using TIPS in place of Treasuries in fixed income portfolios.

As the country’s central bank, the Federal Reserve (Fed) is charged with two overriding tasks: maximizing employment and stabilizing prices. By most accounts, the Fed has achieved its mission on the jobs front. But the same cannot be said for inflation, which has been running lighter than the 2% or so rate the Fed would prefer (source: Bureau of Labor Statistics). Upcoming data will take on heightened importance both for the Fed debate over policy, and also for market expectations.

Prospects for rising inflation come on the heels of the easing of downward pressure on goods inflation. A stable dollar and stable or even rising commodity prices all point to upside potential in inflation figures in the coming months. Meanwhile, the long-awaited signs of wage inflation have shown up, even if wage gains still pale in comparison to prior recoveries. Average hourly earnings in September grew slightly below expectations, but the year-over year figure, at 2.6%, continues to highlight the recovery in wages (source: Bureau of Labor Statistics). Meanwhile, alternative measures that hold the mix of job holders constant show wages growing above 3% (source: the Atlanta Fed Wage Tracker). Add to that survey data from small businesses, which continue to highlight the lack of qualified applicants and a rising share of firms raising compensation.

What does this all mean for investors looking for diversification within their bond portfolio? We believe now may be a good time to consider Treasury Inflation Protected Securities (TIPS). Simply put, these securities offer protection against inflation. They pay interest twice a year, at a fixed rate, and they increase in value when inflation is on the rise, and decrease when inflation retreats.

The impact of oil

As the chart below shows, the relative performance of TIPS vs. nominal Treasuries—(the “breakeven” rate noted in the chart refers to the difference between the yield on a nominal fixed-rate bond and the real yield on TIPS)—has been highly correlated to oil prices.

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Part of the explanation for this is that TIPS are indexed to the headline U.S. consumer price index (CPI), and energy prices play a key role in that reading. So, recent headlines suggesting the possibility of an OPEC agreement to curtail supply have helped to lift oil prices, in turn boosting expectations for CPI. More broadly, the recovery in oil prices off the earlier year lows reflects a balancing of supply and demand, and that appears to lessen the risks of large declines in oil prices—a key downside risk to the relative performance of TIPS.

Substituting nominal Treasury exposure for TIPS exposure can potentially lead to a relative performance gain. But the absolute short-term price performance of TIPS reflects mainly the outlook for real—or inflation-adjusted—rates. With the Fed poised to raise rates in December, real rates will likely increase. However, with rising inflation and the potential for rising inflation expectations, we expect TIPS should outperform nominal alternatives in such an environment. Given that, we see attractiveness in using TIPS as an alternative for core Treasury allocations in fixed income portfolios.

Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.

Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Investing involves risks, including possible loss of principal. 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. Obligations of U.S. government agencies are supported by varying degrees of credit but generally are not backed by the full faith and credit of the U.S. government.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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