TIPS and Duration

TIPS and Duration: Should I buy Short-Term TIPS?

Should I buy short-term TIPS or just a regular TIPS fund?

 

TIPS, like other governmental bonds, have duration. Should you have short-term TIPS, or go with a total or intermediate-term TIPS fund?

Interest rate sensitivity is something I bet of which you are aware, but how does that apply to TIPS? And TIPS duration?

Duration is a bond’s price sensitivity to interest rate changes. With treasury bonds, it measures the sensitivity to changes in nominal (before inflation) interest rates. For TIPS it is a measure of the sensitivity to changes in real (after inflation) interest rates. One doesn’t account for inflation expectations, and the other does!

Let’s dig into TIPS and duration to decide if you should buy short duration TIPS or just a regular TIPS fund.

 

What is Duration with TIPS

Duration can be simply defined for a complicated concept: it is a bond’s price sensitivity to interest rate changes.

Bond price and interest rates are like a teeter totter; as one goes up, the other goes down. If duration is short (the bond will pay out soon), there is not much change in price with changes in interest rates. On the other hand, if the duration is longer, smaller changes in interest rates effect the price much more.

This is because you cannot sell the bond you hold and buy a higher yielding (new) bond when the interest rates increase. No one would pay you that much for your old, lower yielding bond!

The longer the duration, the more the effect!

Said another way, short term treasuries don’t change much in price when there are interest rate increases, where long duration treasuries typically have much larger swings!

What about duration with TIPS? The same concept holds true. If you own a TIPS fund (typically a mutual fund or an ETF), and you have increasing interest rates, then the price of the fund goes down. Short duration has smaller changes, large duration—larger changes.

So now that we are (mostly) clear with duration, should you own short-term TIPS or intermediate-term TIPS?

 

Why You Should Own Intermediate-Term TIPS

Intermediate-term TIPS, on average, pay more than short-term TIPS. This is true with other treasuries as well, as the longer you “give” your money to the government, the more you require in return.

 

duration and tips yield

Duration and Yield of TIPS

Above you can see the yield (average coupon rate) depends on the duration for several different TIPS ETFs. In general, as duration increases, so does yield.

In summary, you should own intermediate-term (or longer) TIPS because the yield is higher than short-term TIPS.

 

Why Should You Own Short-Term TIPS?

Short term TIPS yield less than longer term TIPS. So why bother?

Vanguard seems to think that short duration TIPS correlate better with inflation. This is mentioned in a 2012 White Paper that no longer seems to be on-line in the USA. Luckily, you can find it here ( The long and short of TIPS ) on their Canadian site.

The long and the short: short-term TIPS hedge against inflation. Short duration TIPS track CPI well, whereas their longer duration counterparts don’t, because of volatility. Intermediate-term and long-term tips are just too sensitive to changes in real interest rates to provide a short-term hedge.

I note 2012 was when Vanguard added short-term TIPS to their pre-retirement glidepath, so this paper was their “just so” manifesto.

From their paper:

We found that the return on a short-term TIPS benchmark (of 0-to-5-year

maturities) has been more highly correlated to actual monthly and yearly

CPI (Consumer Price Index) inflation than other segments of the U.S. TIPS

market over the past decade. Although, in practice, all TIPS securities

receive the same CPI principal adjustment, short-term TIPS returns tend to most

closely track actual CPI inflation because of their lower duration and greater

responsiveness to temporary, unexpected inflation spikes.

 

While they note that short-term TIPS are more appropriate for risk-averse investors who want to tract the CPI, there is, of course, no free lunch.

Further from the paper:

Of course, the higher inflation correlation of short-term TIPS comes at a cost—

a lower expected income return versus that of the

broad TIPS market. In this sense, the risk−return trade-offs of investing in a

short-maturity versus a longer-maturity TIPS portfolio parallel those involved

when selecting the interest rate exposure of any other bond portfolio.

 

They conclude that the investor should decide if they care about short-term inflation, or long-term purchasing power which is positive inflation-adjusted (real) long-run returns. And of course, the answer is “both” to Vanguard.

 

So, Which “Hedge” Inflation Better: Short Duration or Long Duration TIPS?

So, which is a better hedge for inflation?

short term TIPS

Volatility and Correlation to Inflation

Above you can see a graph from the same white paper.

Note that blue is correlation to inflation and tan is volatility.

Short-term TIPS correlate best to inflation with the lowest volatility. Gold has reasonable hedging capacity, but at the cost of massive volatility.

Note with the intermediate and the long-term tips, you decrease correlation and actually increase volatility.

Thus, changing to short duration TIPS means a higher correlation with inflation, lower volatility, AND a decrease in yields.

 

The Key: What WILL Inflation Be?

It is most important, when consider TIPS, to remember that inflation expectations are already baked into the price.

Only UNEXPECTED inflation allows higher returns with TIPS. That is, if there is only the inflation that the market expects there to be, TIPS will be priced the same as their other governmental bond cousins.

So, what will inflation be?

inflation, duration and tips

Historical Inflation

Above, you can see inflation changes in the US over the last almost 250 years.

Note that deflation was quite common prior to the 1940s but not since. Remember that the spoken truth about inflation is that we tolerate it at modest levels because it is much better for everyone than deflation. Deflation is to be avoided at all costs, and it seems as if the Fed has done its job here quite well.

It is also interesting to note the inflation of the 1970’s and the decrease in the trend since then.

What will inflation be? Who knows! But, expectation of inflation sets TIPS prices, and short duration TIPS are a short-term Hedge against Unexpected inflation.

 

Short Term TIPS are a Short-Term Hedge Against Unexpected Inflation

Let’s look at expected inflation vs unexpected inflation for a second.

unexpected inflation and tips

Correlation of Asset Classes with Expected and Unexpected Inflation

On the top, you can see correlation to expected inflation, and on the bottom, correlation with unexpected inflation. This is from two different time periods, but the main focus here is on the second to last box on the left.

Look at TIPS and Short-term TIPS with expected inflation (top) and unexpected inflation (bottom). Short duration TIPS are more correlated with both expected and unexpected inflation over both the broad history, and recent history. Of course, it is interesting to know that TIPS haven’t been around for more than a couple decades, so make what you will of the data!

 

Summary—TIPS Duration, Should I buy the short-term TIPS fund?

In summary, short duration TIPS funds have a lower yield. There may be higher correlation to unexpected inflation in the near future than with longer duration TIPS funds. These longer term TIPS fund suffer from too much volatility to allow short-term inflation hedging.

It is interesting to think why this may be the case. After all, the price of TIPS depends on the expected inflation. If people think there is going to be inflation, all TIPS become more expensive to buy.

Perhaps the difference in the duration and correlation with inflation is, in fact, investor’s own sentiments about inflation. That is, it is only because of investors’ concerns about inflation do the price of short-term TIPS go up. Over the long term, sentiment changes cause volatility due to sentiment alone.

Further, short duration TIPS are less effected by increases in interest rates, as is the case with all bonds.

 

What this means to me: you probably need to liability-match your TIPS.

If you have a short-term need for inflation protected cash, consider short-term TIPS to better hedge that liability.

If, on the other hand, you are just sinking part of your “safe-money” into TIPS perchance inflation in the long run, the extra yield (albeit not much!) of the longer duration TIPS is worth the volatility.

 

After all, investors should care more about correlation to unexpected inflation – expected inflation is already baked into current market prices.

 

Tell me when you expect to have unexpected inflation, and I’ll tell you what sort of TIPS fund to buy.

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